Simon French, Rupert Harrison and Sanjay Raja.

Q58 The Chair: Welcome to the Economic Affairs Committee, our fifth evidence session for our inquiry into the UK’s fiscal framework. We are delighted to have three market participants and experts. We have Rupert Harrison, senior adviser at PIMCO; Simon French, chief economist and head of research at Panmure Liberum; and Sanjay Raja, chief UK economist at Deutsche Bank. Gentlemen, we are grateful for your time and thank you so much. We are broadcasting live on Parliamentlive.tv and a full transcript will be taken, which we will make available to you shortly after the meeting to make any corrections that you feel necessary.

I will start with a general question. It is in two parts. First, to what extent does the fiscal architecture and the fiscal rules, the way the Treasury and the OBR interact, register with you as indicators of the fundamental health of the British economy versus the original work and research that you do into the economic fundamentals of the economy? How much does it touch the sides of your view of the state of health or the state of play in the British economy?

Secondly, there is a question of the OBR in particular. I might ask Rupert to say something, given that he was adviser to the Chancellor at the time the OBR was set up. Looking back over the 15 years or so of the OBR’s role at the centre of the fiscal architecture of this country, what can we say about the role it has played? How effective a role has it played? How much has it changed its role over the last 10 to 12 years? Those are two very general questions, and maybe we will start with Simon French.

Simon French: Thank you very much for the invitation. As to whether the OBR is a macroeconomic forecaster—you used the phrase “touch the sides”—of how the UK economy will evolve, I think it sits alongside the other institutional forecasters, most notably the Bank of England and private sector forecasters. I do not think there is a premium or a discount to their headline economic forecast that moves the market.

What I think they have, though, around the time of the EFO, is a time advantage in being able to score the policy proposals put in either a Budget, Spring Statement or some fiscal event, and that has some near-term volatility. There are probably two impacts for the markets. My specific background is equity capital markets. It is the immediate sectoral response of both the policy announcement and the OBR’s scoring of that impact on things. You can think back to the March EFO and the projections for housebuilding as a result of the supply side planning reforms as the market moving in that sector. The other side of the coin is the lead-in, which probably most acutely we saw in the run-up to this Budget. If you are thinking about capital being allocated, speculation on where the OBR would land and the fiscal implications of that decision led to not quite a cessation in the allocation of capital but certainly a noticeable chilling of allocation.

Sanjay Raja: Thank you for having me here. It is a privilege to be here and contribute to the great work that the Economic Affairs Committee is doing on the fiscal framework.

Quickly, on Simon’s point, I will add a couple of things. I think there is a misconception sometimes from a public perspective about what the OBR does. Does it set policy? Does it shape policy directly? The one thing I would add here is that it does neither of those things. If I put on my markets hat, when I think about our clients it is a fourfold perspective of what the OBR has, which is unique to what we do. Number one, it scores policy in a way that we cannot. Its entire job is to appropriately and accurately, as best as it can, score policy independently and provide credibility to some of those forecasts.

The second thing is that it provides economic context. In some ways there may be some challenges, and we may come to that over time. In a slightly strange way, it provides the official forecasts for the Treasury, which not many other independent fiscal watchdogs do. This is a unique position that the Office for Budget Responsibility has that others do not share. Providing the economic context—whether that is growth, the labour market, inflation and so on—allows, in many ways, more credible and more transparent policy-making from the Government at the time.

The third thing, clearly, is providing the best guess of the public finances path, whether it is the fiscal aggregates, borrowing, debt and so on. Obviously, we pay a lot of attention to both the deficit and the debt stock specifically.

The final thing I would say on what that adds is what we do not necessarily do to the extent and the scale that the OBR does—it is an important job, and again we will touch on this in a second, I am sure—is scoring the Government’s policies against the chosen fiscal framework at the time.

To your question, Lord Wood, yes, there are a lot of things that the OBR does that we would not do. Even going beyond the economic and fiscal outlook, I think that there is a very important element from the OBR. I would say one of the more important things that it does that gets undervalued is the fiscal risk and sustainability report—things that we do not focus on that have maybe even more value to the near and medium-term perspectives that they provide.

The Chair: We will definitely come back to that. Rupert, over to you. Maybe you could say something about the history, given your role in the creation of the body.

Rupert Harrison: On the first question, I largely agree that, when it comes to the pure macro forecasts on growth and inflation, the OBR is just another forecaster alongside the Bank of England.

However, what the OBR does that no one else can do, because it has the depth of information that it has on public finances, is translate the economy into what that means for the public finances as well as the scoring. No one else can do that. That is highly relevant for market participants to understand what the translation from an economic forecast into the forecast for the public finances is, and therefore the fiscal rules and what the Government’s potential response might be. So the OBR is highly relevant as a market participant. If you think the OBR forecast means that the Government are going to tighten fiscal policy because they need to, that is highly relevant for gilt markets, for example.

That leads into the original intentions behind the creation of the OBR. The OBR does two very important things, and only one of those things was originally intended and foreseen. That was to bring independence and credibility to official forecasts. The context had been that, in the aftermath of the financial crisis and in the run-up to the 2010 election, a perception had grown that the forecasts were more politicised—there were some complexities to that, which we can come on to—and therefore there was a loss of trust in the UK forecasts. The OBR was created to bring independence and credibility at a time when the incoming Government were concerned about creating credibility and enhancing the credibility of the system. That it has done.

The second thing it has done—which was not really anticipated but is as useful, if not more useful—is bring about a huge increase in transparency and the amount of information that is available. Because it produces the government forecasts rather than just auditing them, and because it is right inside the Treasury and government departments with access to the underlying data assumptions, revenues and so on, it represents a huge transfer of power away from the Executive towards Parliament and citizens. Prior to the OBR, we were basically fed what the Treasury was allowed to feed us, whereas now the OBR is an actor inside government that publishes everything. That is extremely awkward very often for politicians, but almost always a good thing.

The Chair: Do you think the OBR has grown into a device for transparency and de facto transfer accountability to others outside the Executive but not to the OBR itself? You would not say the OBR has become a powerful actor in its own right.

Rupert Harrison: It is powerful in the sense that when we get, like we have recently, these very narrow judgments against fiscal rules, it is influential, because the Government have said they are going to follow a certain fiscal rule and the OBR generates the forecast on which that is based.

What I am saying is that it is a huge transfer of power away from the Executive, given the amount of information for markets, media and Parliament to process. If you look at the amount of information in the OBR publications—whether it is the EFO, the research or the fiscal risk report—it is a totally different world from pre-2010, when you just had the Red Book, a book that was written by special advisers with the help of civil servants effectively, and you found out what the Government wanted you to find out.

The Chair: Very interesting. Thank you very much.

Q59 Lord Lamont of Lerwick: Sanjay, you mentioned the sustainability report and how in some ways you thought that was more important. Do the three of you have any views about that and about how the sustainability report might be made to have a higher profile and to get people to pay more attention to it? Notwithstanding the rather alarming, to me, report that was given earlier this year, it was amazing how little impact it had in the wider political world. Rupert, would you like to comment on that?

Rupert Harrison: It has an impact when it comes out. It always gets a lot of coverage, so I guess that is an improvement from zero normal attention to long-term fiscal risks. At least the OBR puts a peg, at least once a year, for that focus.

I think the reason why it appears and then recedes is that there is nothing that a Government are targeting or being judged against in that report. Governments are not setting 30 or 50-year targets, and therefore it does not become politically relevant. However, I think it is an important part of the backdrop to the discussion and so is better than nothing. I do not have any particular ideas on how you can make it more relevant.

Simon French: I think there is a risk of a false dichotomy or a separation between the long-term report and the short-term report; they feed each other. We will probably come on to look at the questions you are likely to pose about the future of the OBR and the requirements of the OBR and the counterfactual should the OBR not exist in terms of its EFO and its five-year forecast. Part of the reason I believe it has that salience is that everyone is aware—or certainly market participants are aware—of the long-term structural challenges both to the tax base and to the spending envelope. Therefore, to some degree, because an accumulation of short terms become the long term, the disciplines required in fiscal rules are a necessary function. At the risk of pre-empting future questions, the future of the OBR’s EFO is, I think, intrinsically linked to whether any Government address things that are raised in the fiscal risk report on an eroding tax base and the liabilities associated with principally the cost of ageing and climate change.

Sanjay Raja: To build on that quickly from my side, there are two reasons that I would point to as to why it maybe does not get as much excitement as the others. One is, to Simon’s point, the fiscal framework that we have is basically three to five years, so the focal area always moves from the very long term to the very near term.

From a market perspective, I would add one thing. There are two things that, in my mind, the market cares about at the end of the day at any given fiscal event. One is a checkmark for whether the Chancellor has met his or her given fiscal rules and the second is how much debt the Government will issue. No market player or participant, as far as I can tell or that I have spoken to, has asked about what the debt issuance profile looks like 10, 15, 20, 30 or 40 years down the line. The focus is very much myopic. Markets are a bit more simple than I think people give credit for. They see what is in front of them. In fact, even in the EFO that came out on 26 November, from a client conversation perspective the focus has always been on the next two or three years because market participants tend to discount what happens beyond the three-year forecast.

Simon French: There is perhaps one exception, which is this July’s EFO, which showed the declining institutional demand for long-dated gilts. I did feel—my fellow panellists may have different views—that that captured fund manager interest in who is the long-term institutional buyer of long-dated gilts. I think that really cut through. Perhaps the answer to the second part of your question, which I ducked in my first answer, is that if the topic is sufficiently relevant to assets that sit within portfolios right now and you are worried about the potential to sell those off before they reach maturity, then it will capture market interest and, by extension, get more coverage from the media, both financial and mainstream.

The Chair: Thank you so much. We need to move on.

Q60 Lord Blackwell: I would like to move on to the interaction between the OBR and the fiscal rules. You have made the point that the OBR can help produce better forecasts because it can score government spending and get a better grip on debt issuance. That is true regardless of whether the Government have fiscal rules or not. To what extent does the market care about the fiscal rules and whether they are being met? I can imagine that the existence of fiscal rules is a positive in the market because it implies some sense of discipline, but is it particularly important to the price of gilts whether the Government have met their fiscal rules or not, or is all the fuss around time margins perhaps a distraction from the underlying economics and future trends?

Rupert Harrison: The markets definitely do care about fiscal rules because they are a signal of likely government behaviour. The Government choose the fiscal rules and set how they are going to meet them, and the OBR is the judge against that. I think that if a Government were to miss their fiscal rules and do nothing about it, that would be a signal to markets that there had been a downgrade of the priority of the fiscal rules. I think that there would be a clear response.

It is not necessarily that markets think that the fiscal rules are the right rules, but they are the Government’s rules and there is a signal to be learned if the Government cannot and will not or are not able to meet their rules. There were some examples recently. Just this year, you can see that markets are very sensitive to these things. There was the day when Chancellor Rachel Reeves was filmed in tears in the House of Commons, and the long end of the curve sold off 15 or 20 basis points. That is a big intraday move because people wondered if she was going to resign or be replaced by someone who might have a different attitude to the fiscal rules. I do not think this is an imaginary sensitivity. It matters because they are a signal of the Government’s political intent or political ability to get through the required measures.

Lord Blackwell: So it is a signal about what the Government might do rather than whether the margin is smaller.

Rupert Harrison: Yes. I think that the margin issue has been extremely unhelpful. It clearly has been extremely unhelpful to have such a narrow margin against the rules, because it has created what the IFS calls a Groundhog Day every six months.

It is clear that Rachel Reeves and the Treasury agree, because they went to enormous lengths in the most recent Budget to increase the headroom. To find £11 billion of tax rises—to go from £10 billion to £22 billion—and not spend those tax rises on any goodies is an extremely painful political decision. Clearly the Treasury agrees that small headroom has been a problem. It has clearly been a problem politically because of the sense of chaos it has created and it has also been an economic problem because it has created a sense of uncertainty about future policy that has been difficult for individuals and companies to navigate. I think that has been an unfortunate outcome, but that is a result of the choice by the politicians to run such a small amount of headroom.

If you do the comparison relative to previous Governments, Rachel Reeves can fairly say that her headroom is quite similar to Jeremy Hunt’s headroom in his Budgets, but it was pretty clear to everyone that that was a fairly exhausted Government limping towards an election, with quite a short horizon. A much better comparison would be to the changes after 2010, when you had a new Government, or to 1997, when you had a new Government. In both those situations you had a new Government at the start of a Parliament who gave themselves much more headroom and therefore created much more stability.

Simon French: This was the first EFO that I can remember in 15 years where the interest of investors on the way in and on the day was more focused on inflation necessarily than the fiscal rules. That sounds like quite a perverse thing to say. But if one thinks of previous periods where inflation has become topical—2021-22 being the most obvious—that was a conditional assumption based on energy curves largely in the potential government response but largely conditioned on a swap price taken externally.

This time around, UK plc having been scarred—I am interested in Sanjay’s view on this—by the quite extensive pass-through of oncosts of employment through the employer national insurance package, the national living wage, the prospect of the Employment Rights Bill, most of the publicly listed companies that we work with that were looking at the EFO and the OBR, were not so much interested in the scale of taxes levied on households or businesses but in how inflationary that would be and how that would impact margins and the aggregate CPI picture and therefore the Bank of England’s response function.

As I say, it was the first time in 15 years that the reaction to the fiscal rules was slightly below what they thought the market would perceive as an inflation reaction.

Sanjay Raja: I think that the fiscal rules are somewhat mistakenly seen as synonymous with fiscal sustainability, and that is far from the truth. We can see that with the debt projections and the borrowing projections. Yes, they may come down over the next four or five years but it does not necessarily put the public finances on a materially better footing.

One thing I would add to Rupert’s point about the fiscal headroom is that clearly it has received a lot of attention, I think for the right reason, but there is a slightly nuanced point that I would raise here. I do not think that the market believes the fiscal headroom. It is a number that is estimated out in five years’ time, so it is conditioned on forecast growth, forecast labour market projections and inflation projections over the next two, three, four or five years. I pride myself on forecasting—I think we are one of the best forecasters in the country. We use Bayesian methods to try to understand what is happening with consumption, investment and trade. Geopolitical uncertainty has made it very difficult to forecast accurately over the next two or three years, but getting a forecast right in five years’ time is better than a crystal ball; that is divine providence. It is a gift from God as opposed to an accurate forecast. It is like trying to pin the tail on the donkey 50 feet away, blindfolded, through thick fog. You just about may get the direction of travel right but you certainly are going to miss.

This is not a slight, by any stretch of the imagination, to the OBR by the way. It is an issue we all face as forecasters and it is something that we have to grapple with. When we hyperfocus on the headroom, a number that almost certainly will not be met or will not be realised because of events that will take place over the next year, two years or three years, it sets a very interesting precedent.

From a market perspective it is almost a checkbox exercise. The obsession over the headroom has built because of the policy volatility it has created, as opposed to saying, “This number is believable and we can now rest easy that the Chancellor has more than doubled her fiscal headroom”. It is more about whether we will go into the next fiscal event, six months down the line, fine-tuning policy. Does it raise fiscal risk? Does it raise political risk? That certainly is one of the reasons why the market loved the Budget. It is not because they bought into the fiscal headroom per se. It is because the debt issuance numbers looked better, the gilt remit came in a little lower than expected, and, ultimately, it felt like the Chancellor and the Prime Minister had bought themselves time without going back into the market and having to fine-tune and fiddle around with fiscal policy.

To Simon’s point, yes, there has been an acute focus on inflation, mainly because from our estimates—take it with a pinch of salt, as it is a wide range - we are economists—based on the last Budget the inflationary impact was something around 50 to 100 basis points on headline CPI. From the payroll taxes and national living wage to administrative taxes—the dutiable items that also saw inflation-related adjustments—taking all that plus the indirect effects, it was quite substantial. I think that the market was very much looking for whether this Budget would give the Bank of England a bit of runway to cut rates potentially into the next year.

Lord Blackwell: Briefly, do you think the media focus on the headroom has been unhelpful, or is it the way that the Government and the OBR focused on it that created that?

Rupert Harrison: I do not think you can blame the media. The media are picking up on the fact that a low amount of headroom means it is very likely we are going to get policy change. When the Treasury feeds speculation about policy change, it is fair game. I totally agree with Sanjay’s point that the benefit of high headroom is mainly that you are signalling less probability of future policy change and therefore more stability, and that means the media will be less interested in it.

I agree with Sanjay’s point about time horizon. I think that it is increasingly clear that fiscal rules focused on a four to five-year time horizon are quite unhelpful. First, the forecast is very difficult on that horizon, and, secondly, there is the issue for repeated Governments, including the Government I worked for, that when you have spending totals that are outside of the spending review allocations it is far too easy for Governments to meet their fiscal targets by just tweaking the total spending assumption for years where there are no allocations to departments. That is almost always in years four and five. I think that it would be a much more credible framework if fiscal rules were focused, as they will be eventually—I think that is a good decision by Rachel Reeves—to get to a three-year horizon. That is much better for both those reasons. That is also the reality for PIMCO and, I suspect, other market participants.

It is quite noticeable now that this is the fifth year in a row since the pandemic that the UK is running a budget deficit of about 5%. The UK looks pretty good on its projections on getting to below 2%. If that is delivered, the UK will look good internationally, but all that reduction is promised; none of it has yet been delivered. I think markets are now very focused on the next year or two of delivery, from 5% down to 3%. Three per cent is also a very relevant number because of the UK’s debt dynamics. A deficit of around 3% is roughly where you stabilise the debt to GDP ratio. I think that maybe markets now will be very focused on delivery over the next couple of years for that reason.

Q61 Lord Londesborough: Sticking with headroom and the fiscal buffer, my question is in two parts. The first is about whether the current fiscal rules incentivise Governments to operate without a sufficient fiscal buffer. If you believe this, what is the impact on investor behaviour?

I will add a little context to save you having to provide it. As you mentioned, Rupert, Chancellors Hunt and Reeves have operated, up to a couple of weeks ago, with a very narrow headroom, on average £10 billion, whereas for the previous Chancellors in the previous 10 years the average was £30 billion. To be fair, the current Chancellor has just doubled the headroom from £9.9 billion to £21.7 billion. But when you read the OBR November report, it puts it in context that this is only around two-fifths of the median, £54 billion difference between our forecast for borrowing and financial outturn four years hence, so it remains a very small margin compared to the uncertainties around our economic forecast.

The question is, essentially: do the current fiscal rules incentivise Governments to operate without a sufficient fiscal barrier and how does that impact investor behaviour?

Rupert Harrison: I do not think that the fiscal rules have incentivised Governments to do this, and they certainly should not, because it has been an absolute political disaster for the Government. I think there has been quite a clear signal that running fiscal rules with a very small amount of headroom is the thing that is highly risky. I suspect you will see future Governments trying to avoid making that mistake, because it has been such an obvious political mistake.

When it was Jeremy Hunt doing it, you could see at the time the political dynamics of that Government—whenever there was any spare headroom in the forecast presented to the Chancellor, it was spent up to the max on the latest desperate attempt to move the opinion polls, normally a cut in national insurance. It was running on the absolute bare minimum, because his real horizon was nine or a maximum of 12 months.

The mistake was to take that as the baseline initially. Your first Budget is the moment when you can take the big, difficult decisions, and create proper headroom, which is useful economically and politically. I do not think that you can blame the structure of the fiscal rules. It was just an unfortunate decision. I suspect that, with that first Budget, and the interaction with the promise not to raise income tax, national insurance and VAT, once you had maxed out all the available tax rises they could not quite get enough to do what they wanted to do on capital spending and spending for the NHS, and to create enough headroom. The thing that gave was the headroom. I suspect that future Governments will not make that mistake again.

Simon French: Anticipating the question, one of the privileges that I have—and it is a privilege—is running an equity research department. I asked my fellow analysts what a reasonable presentation by a plc CFO would show in tolerable in-year variance. The number that came back was about 5%. If you reverse out of £1.3 trillion-worth of public spending at a 5% variance, that looks to be about £65 billion. That is not a million miles away from your median, albeit about 2x the mean of the period since 2010. It is rife with political challenges to get there but, if you are trying to draw a parallel between government accounts and the accounts that are presented by a plc, that would be the number you would come to.

There is another point I would make at this juncture about the market’s reaction to lower headroom—I am mindful of saying this to the left of the architect of the 80:20 ratio of tax and spending in terms of fiscal remediation. I think one of the problems that the Government have right now is they have not codified what their ratio looks like. Most people in financial markets realise that events come out of leftfield that could add or indeed eliminate headroom. It is about what your response function looks like—what will do the heavy lifting and on what ratio. Unless I have missed it, and I may have missed it, the Chancellor has not come out with a ratio of her own. Therefore, the feedback I got from investors is that they are going to assume a 100:0 ratio because that is the only conclusion one can draw based on the policy U-turns on spending cuts over the course of the summer, specifically on welfare reform, winter fuel payments and, eventually, the two-child benefit cap.

Sanjay Raja: I think that what we have learned in the last six to 12 months is that you run small fiscal headroom at your own peril. That is why, in some ways, the Chancellor came out on 26 November more than doubling her fiscal headroom, which was an upside surprise on the current, more binding primary stability rule, at £24 billion. She also increased her secondary room from £15 billion to about £24 billion. I will not say very much about the third rule, which we do not talk about, the welfare margin. It is still met by less than £2 billion.

I thought I was going to be very controversial when I said this, but after hearing Simon I will go for it. We have said that we should be thinking about something like a fiscal lock, and I have put a number of 1% of GDP, which would be roughly about £30 billion to £35 billion. I thought that was reasonable. Five per cent sounds even better, perhaps, in building up that fiscal buffer space. At minimum, it feels like that would give you less policy political volatility day to day and allow you to run policy in a much more meaningful manner, as opposed to always fiddling around the edges to try to make the numbers work.

Q62 Lord Londesborough: Thank you. The second part of my question is in relation to the arguable policy volatility caused by operating with such narrow headroom. Do you think that the Government adopt counterproductive or suboptimal policies simply to operate within the headroom?

Take in particular the balance between fiscal rectitude and economic growth. If we go back to the private sector as an example, the board appears to be represented by a CEO and a CFO but lacks a CMO or a head of growth. While this Budget appears to have broadly satisfied the markets—it certainly has not frightened the horses—and Labour’s Back-Benchers, much of the private sector is saying, “What about the growth strategy?”, with a feeling that, as I say, fiscal discipline is dominating and economic growth, the so-called number one objective, is being buried underneath. What is your view on that, Rupert?

Rupert Harrison: I do not think that fiscal discipline is at odds with the growth strategy. It has to be a foundation for any growth strategy, because if you do not have fiscal discipline, as we saw in 2022 and in other countries at other times, everything else goes out the window.

What your question really points to is the nature of the policy-making process that this small amount of headroom drives, in that you get short-term decisions to scramble around for some money to make the headroom add up. I think that was illustrated in the Spring Statement, where we got a set of welfare reforms—particularly the PIP reforms, which were clearly put together quite quickly—in order to hit a number. That was one of the reasons why they then fell apart politically. This was not a coherent and long-planned set of welfare reforms; it was a quick job, to try to produce a number. That is a product of bad policy-making coming from the instability that comes from having such a small amount of headroom.

Let us say a Government started with a good amount of headroom and then faced a very adverse economic shock, and was facing question marks about fiscal credibility and jittery gilt markets. It would be very important in those circumstances that the Government take action to meet the fiscal rules. It is better to respond than not respond; if you do not respond then you are sending a signal that you do not have the political ability to deliver sustainable public finances.

Of course, where bad policy often comes in is the interaction between that need for short-term action and all the things that you have ruled out doing. In this Budget, the obvious thing to do would be to raise income tax. Raising income tax is not particularly economically distortionary and it is not particularly anti-growth; it is a very broad-based simple tax. It is the interaction of a Government having to find amounts of money in a short period, having ruled out a lot of sensible things, and then falling back on other things.

Simon French: I would add to the point around the tax lock and the political decision to rule out the three big taxes, or at least two and a half of them, at the last election. We tend to look at it through the lens of saying that they are the cleanest way of doing things to raise money. What we do not always do is look at the residual 30% and how that can have quite significant microeconomic impacts on the choices of individuals, with founders of companies looking to crystallise value, transact, and mergers and acquisitions. We saw quite a lot recently, with the two Budgets this Chancellor has had and the Spring Statement, of founders delaying decisions because of speculation over things such as exit tax and capital gains tax. It is the impact of looking elsewhere within the taxable base. While they are relatively small in public finance terms, they are very significant to the choices of individual actors and how they choose to either crystallise value or grow their business.

A more substantive answer would be on the growth side of things, and this brings the OBR back into scope. A pet theme of my economic writing is that the UK is far less of an outlier on a lot of metrics than perhaps our media or investors perceive when you look at growth on a per capita basis. However, there are areas where the UK does look like a very clear outlier.

A personal view is that the OBR is a microeconomic investigator. The two big trends that I think have defined the UK’s poor growth performance, at least per capita since the global financial crisis, have been the move from UK energy costs in line with the rest of the world to the most expensive in the world over two decades, and the move more recently from low pay—what was then the national minimum wage and then the national living wage—at about 48% of median earnings to today’s 66% of median earnings, which makes it a considerable outlier. As the cost of doing business—in energy or in deploying labour into the product mix for growth—those feel like significant growth headwinds. Unless I have missed an evaluation of those two policies, the OBR has been relatively silent for my liking as an independent fiscal watchdog.

Sanjay Raja: I am afraid I might give you a bit of a standard textbook economics answer on this. The answer is that it depends. I think that it is important to have a “get out of jail free” card. There needs to be an escape clause when there is a downturn, a global financial crisis or a pandemic, where we can outrightly define. Where I get a bit more nervous, and where I think the market will get a bit more nervous, is when we talk about whether economic weakness should allow for a deviation from or suspension temporarily of the fiscal rules, because then we come to the question about how we define economic weakness.

If I look at the OBR’s forecast at the moment, the independent fiscal watchdog here in the UK projects the output gap to be about 0.6 percentage points. Now, the UK is the fastest growing economy, as we all know, in the first half of this year, and likely will be the second fastest growing economy in the G7. We are projected to grow at 1.4%. That looks like that will be delivered, by and large, yet if I look at underlying growth there is clearly a different story. Should that allow the Treasury to step in and suspend the fiscal rules to say, “Well, 1.4% growth because of X, Y and Z does not quite translate to what we think we should be growing at from an underlying basis”? From a definitional perspective, it opens up a can of worms that is a lot more tricky to investigate.

When the evidence is quite obviously that we are in a downturn, we should allow for an escape clause on the fiscal rules. But where it is, as we see today perhaps, that real GDP per capita may not be growing as we would like it to be yet the UK economy is growing at a pretty decent pace—it has outpaced almost every forecaster’s expectation, and we were on the more optimistic side coming into this year; that has surprised us as well, to the upside—you get into the question of when we can start to define when fiscal rules matter and when they should not matter as much.

Q63 Lord Davies of Brixton: My question rather handily follows on from that, if not overlaps with what people have just been saying. The position we are in is that there is this controlled variable—the fiscal space, or whatever you might call it—and it is all about housekeeping, essentially. Are we going to raise enough money? What are we spending it on? There used to be a lot more discussion in drawing up budgets with a grander narrative about controlling the economy, which is essentially what Sanjay was talking about. Should the need for countercyclical movements be built into the fiscal rules or is it always going to be an add on as the last remark suggests? What is taxation for? It is for a variety of reasons. It is not just about raising money to cover public expenditure; it is about controlling the economy and it is about social justice. By focusing on this headspace, have we gone away from that grander view of what taxation is for?

Sanjay Raja: I do not necessarily think so. I would say two things to that. One is that the fiscal rules were chosen by the Government and Chancellor, so in many ways, as should always be the case, fiscal policy spending decisions and tax decisions should always be taken by elected officials and should not by any stretch of the imagination be influenced by the Office for Budget Responsibility. Those taxation and spending decisions, as they are chosen by the Government, should be prioritised, but within the context of where they feel the fiscal rules can play an accommodative role.

The Chancellor last year in her maiden Budget delivered two new fiscal rules. We have had plenty of them, and I do not think that the market took that as a negative surprise. The market expects every new Chancellor and Government to potentially adopt a fiscal rule platform that matches the agenda that they were elected on. In many ways, for me, the fiscal rules work around those decisions that you just mentioned, which certainly are very important, but there are always trade-offs.

To go back to Simon’s point, the fact of the matter is that we are now a lot more dependent on foreign investors to buy UK debt. This is now creating a lot more constraints. We do not have a domestic investor as we did 10 or 15 years ago. If we go back to 2000, insurance funds and pension funds were buying a lot of UK debt—about 70% of that. Now, that number has gone down to 20%. It is hedge funds, institutional clients and overseas investors that are buying debt, so this additional trade-off has been added on to the calculus. I think that Governments need to be aware of that in setting their own fiscal framework, whether it is the fiscal rules of their choice and in accommodating their spending and taxation plans.

Simon French: My personal view is that I am uncomfortable with a fiscal rule that has an explicit low growth knock-out. That is, in effect, taking sides in the debate. It is an active debate in economic circles as to whether for all downturns in growth there should be a fiscally stimulative response. It did not require a low growth knock-out, for example, during the pandemic to fuel a big fiscal expansion. It was the right answer. The bond market was signalling that, the market was signalling that and the economy was signalling that. There must be a discretionary element for Governments, and that comes back to one of the opening remarks that Rupert made.

I would also say that many of the challenges the UK’s growth picture faces right now are to my mind structural. They are an impairment of the supply side of the economy. They will not be addressed in any other way, I am afraid, but by higher inflation and a further expansion of fiscal policy. To some extent, a fiscal rule that hard codes low growth without a diagnosis of where that low growth comes from risks the wrong macroeconomic policy lever being pulled.

Rupert Harrison: I cannot think of a recent example where we have had fiscal rules stopping a Government taking short-term countercyclical measures that they would otherwise have liked to do. It has not happened. The fiscal rules that we have had over the last 15 or 20 years or so have all had components within them that allow the automatic stabilisers to operate or some amount of discretionary countercyclical policy. They do that by being on a three to five-year horizon. If you have a fiscal rule that is targeting that horizon, that allows you to take some measures in year one or two and then bring it back in year three, by which time all forecasts will say that the cyclical picture is improving, or you have had rules that have targeted an explicitly cyclically adjusted measure.

The first rules that George Osborne had targeted a structurally adjusted current deficit, which explicitly allows automatic stabilisers to operate. Or you have the situation in the pandemic, where, from memory, I think Rishi Sunak suspended the fiscal rules because it was an extraordinary situation. Interest rates had fallen to zero and there clearly was not an immediate fiscal constraint. I think there was some agreement that they would kick back in at some point once normal service resumed. Markets tolerated that because it was clearly communicated by the Chancellor.

I do not think that we are in a situation where the fiscal rules have ever stopped a Chancellor taking the countercyclical action that they would have liked to have taken. Improving the structural growth of the economy is much harder and a totally separate question. I do not believe they are preventing that either. It is the difficulty of doing it that is preventing that.

Q64 Baroness Wolf of Dulwich: I would like to come to the topic of forecasting and the OBR as a forecaster. We start with the basic point that all forecasts are wrong and we cannot live without them.

I would like to ask each of you whether you have any clear views about whether there should be major changes to the way the OBR carries out its forecasts and whether it should be the official forecaster. We have had a number of views on this. The obvious question was whether the Treasury should resume its role as a macro forecaster for government. There are a couple of other issues to do with the way the OBR forecasts and the question of whether or not, particularly for productivity, it should go for the market consensus or whether, in fact, even though all forecasts are wrong, it is none the less true that there are central components of the way the OBR carries out its forecasts for which there are no market equivalents, because it has access that other people do not have.

Do you accept the view that the OBR forecasts are so generous and bound to be? Do you think that there could or should be major changes in the centrality of the OBR as the Government’s forecaster?

Simon French: I will take the second part, if I may, which is on changes to the way the OBR approaches its forecasts. The frustration I have, and maybe I should be careful what I wish for, is that private sector forecasters, of which I am one and Sanjay is one, have a bit of an advantage over the OBR and the Bank of England, in that we can disbelieve stated government policy.

There have been a couple of examples of this. One of those, which is quite long-dated, is the insistence that it is government policy to raise fuel duty—I have forgotten the number of fiscal events where that has been dealt with but it is definitely into double digits. The OBR, as far as I am aware, can be very critical and very grumpy at press conferences but cannot just plug into its forecast a different assumption. The Bank of England also has this impediment. We both had a big advantage in mid-2022, when everyone knew there was an energy bailout package coming. But until Liz Truss announced it, the Bank of England, in its August MPR, could not condition its forecast on that, whereas I could say to clients and could plug into my forecast that it was coming, and therefore inflation is probably not going to reach 18% but will be capped.

That feels to me like a strange dance. I understand from a constitutional—maybe I am using the word inadvisedly—or proprietary standpoint that it would be very difficult for an independent OBR to do that. But if everybody else in the private sector has concluded a policy response function that is different from stated government policy, I think the powers of the OBR to call that out, and by extension the Bank of England, need to be strengthened.

Sanjay Raja: There are a couple of things I would add to what Simon has said. Despite my reservations for long-term or medium-term forecasting, it probably makes sense for the OBR to do what it does, for a number of reasons. One is, as Simon rightly mentioned, that we all base our forecasts on very different underlying conditioning assumptions. At Deutsche Bank we will base our forecast on what I expect the bank rate to be over the next few years as opposed to the market curve, which can be right or potentially wrong. We use house forecasts for oil and gas and everything else in between. Fiscal policy is obviously very important. We do not necessarily take what the OBR says as gospel, so we can adjust accordingly, thinking about fiscal slippage and everything else in between the lines of the OBR EFO. That creates a lot of heterogeneity in the forecast. When it comes to defending the projections from a market-based projection, it becomes a lot more complicated.

Even from a time horizon perspective, I think that you will find that not everyone will forecast up to five years, even though it feels like that should be a reasonable prerequisite. Most people will try to forecast two to three years in advance, and certainly not four or five years, for some of the reasons that I mentioned. You get to the point where it becomes a lot more difficult to triangulate some of these projections.

The last thing I will say on that is we do not all forecast the individual several hundred variables that the OBR needs to work out its projections for individual components of receipts and spending. In many ways, having a consistent framework as it does, as flawed as it may be—again, this is not a slight to the OBR; it is every forecaster’s framework—gives us a credible framework to work with, to challenge and potentially explore where we can make some improvements.

On the Treasury side of your question, about it resuming its role, I think that the market would be very uncomfortable if the Treasury, after not having done these macro forecasts for the better part of 15 years, then resumed control of these forecasts. I think that there would be questions from a market perspective about political pressure, credibility and the transparency of the forecast—things that Rupert mentioned at the very start. Those concerns would come back to the forefront. That would be a big question mark, and another volatility event that we would like to avoid.

Rupert Harrison: I totally agree with that. I think it would be taken as a very negative signal, because the market would say, “Why are the Government doing this?” Sanjay is right to point out that what we ask the OBR to do is a much harder job than most independent forecasters, particularly the fact that we ask them to go out to a five-year time horizon. We should judge them on that basis, because two years is a lot easier to forecast.

Baroness Wolf of Dulwich: Should we stop asking for five years?

Rupert Harrison: To the earlier comments, I think we all agree that fiscal rules are probably better judged on a shorter horizon, but it is a useful service to give a five-year horizon because there are trends in public finances that are only apparent on that horizon. It would be a shame to shorten the forecast—shorten the rules, maybe. On asking it to take an average of productivity growth, again to Sanjay’s point, what the OBR is producing is internally consistent; forcing it to adopt something external would make that a lot more difficult. The OBR has access to a huge amount more information on public finances and the drivers of individual receipts. I have experienced many times that the OBR has, frankly, a better understanding of the national accounts than most forecasters, as it is just closer to those, so that brings useful insight.

I will flag one comment on the OBR and forecasts that we might come on to in other questions. There is one area where I think the OBR is starting to make a potentially quite dangerous mistake that it should pull back from, which is its increasing involvement in assessing the impact of government policy on future productivity. That is a very dangerous, slippery slope for the OBR because it draws it into much more contested territory. It is asking it for spurious accuracy—the idea that it can put a number on the impact of the Government’s planning reforms on productivity growth. It did introduce in the most recent EFO, after an external review, a de minimis of 0.1% of GDP. I would have a de minimis of about 10 times that because I just think it is arbitrary accuracy.

It is also bringing the OBR into the Government’s policy-making process in a very dangerous way. You have Treasury Ministers and special advisers going to other departments saying, “Hello, Planning Minister. No, you have to do your policy this way because otherwise the OBR will not score it”. If you are the Planning Minister or the Welfare Minister, that raises some very legitimate questions such as, “Why is my policy being determined by a quango in the Treasury telling me what it will and will not score?” I really think that the OBR should get out of that business altogether.

Of course, when you have a major event such as Brexit where it takes a view that there is a 4% impact on the economy, then there should be a de minimis that allows them to take that into account. The OBR comes in for a lot of criticism and it exists by political consent, and therefore much more important is preserving its independence. It should get out of those much more contested areas. For Governments on that kind of policy, it should be show, not tell. If you think that your policy will deliver faster productivity growth, then great: demonstrate it.

Simon French: Perhaps in brief defence of the OBR, having criticised the approach, if the private sector was asked to come up with an alternative estimate on productivity—which it does not widely do; I do not think it is captured in the independent collection of forecasts that the Treasury collects—the data would be so noisy going into the supply-side stocktake. I think it is widely understood that if you took the HMRC estimate of output per hour and tried to triangulate it with what you are getting from the Labour Force Survey, you would come up with two very different answers. The OBR is just one of many individual bodies looking at that and asking what it tells us about the trend, notwithstanding the impact of public policy decisions such as planning and Brexit. In terms of underlying trend, there is a huge data fog right now. I am not sure the private sector is any better at trying to take sides in what is a diverse picture, at the moment, on where the trend in UK productivity is heading.

Sanjay Raja: If I may just add to Rupert Harrison’s point on danger zones, one thing that caught me off guard—and, I am sure, may have caught others off guard—in the inaugural Budget was the OBR making an assumption on what government policy would mean for gilt yields. That was interesting in and of itself because this time around, when we knew that there would be a plethora of disinflationary measures, the question that clients, international and domestic investors, were asking me was, “Do you think the OBR would make a similar judgment but in the opposite way?”; that is, to reduce gilt yield forecasts relative to the market conditioning assumptions. That is a slippery slope as well, to the point that Rupert mentioned, and something that distorts the consistency of the forecast, just to be aware. Lastly, instead of taking market variables, we could maybe have more structured pre-forecast conversations with the private sector. Corporates, firms, think tanks and so on can maybe help sharpen some of those projections, as opposed to wholesale shifts in the forecasting framework.

The Chair: We have a couple of follow-up questions to what you have just said. Lord Lamont, did you have your hand up or did I misread your hand?

Lord Lamont of Lerwick: I put my hand up and I have taken it down.

The Chair: Excellent. You have done a U-turn. Lord Turnbull?

Q65 Lord Turnbull: I do not know whether you had access to or followed Robert Chote’s evidence last week. He looked at this question of where the balance lies between having an OBR that makes its own forecast and an OBR that is embedded so that it has to take the Government’s projections. I thought he came out fairly strongly in favour of maintaining the embedded model, for exactly the reasons that you raise, the amount of information and transparency you get with that that outweighs the benefits you get from having someone who is just a scrutineer. At some point when that evidence becomes available it would be worth—

Rupert Harrison: I always want to agree with almost everything Robert Chote says, so I am glad he said that and it is absolutely right. If the OBR was a sort of passenger and auditor of the Government’s forecast, then you would still be in a framework where the information presented was under the control of the Government. Because the OBR is itself the forecaster and really gets into the weeds—it goes to talk to the DWP about trends in benefit spending, it really gets under the hood in HMRC about individual taxes and revenues and how those will evolve—it is able to collate and then publish a huge amount of information that was previously not available. The transparency therefore does go hand in hand with the role as forecaster.

Simon French: To that point, the monthly profile of tax receipts and public finances that the OBR has now published is a welcome bit of transparency in terms of trying to do a mark to market in-year assessment. What is perhaps missing in that augmented model is that there is quite a delta in-year, which the OBR expects in H2 of this fiscal year to close up quite significantly. It produces monthly commentary. What it tends to do is describe the moving parts of where it arrived, rather than perhaps score in real time the likelihood of that being achieved. There is a pretty vibrant debate at the moment as to whether the fiscal year 2025-26 projections, which are conditional on some pretty punchy tax receipts in January, will crystallise.

Q66 The Chair: Can I ask a quick follow-up to Rupert’s point about the materiality threshold the OBR has put in? He said it was good that it is there but he would have it 10 times as high. That raises the general question of whether the fiscal framework of the sort that we have in the UK is stopping Governments, or whether there is an additional contributory factor to Governments not having the political courage to take long-term transformative decisions on the knowable transformations that we all face. That could be climate change adaptation, demographic change or defence needs. If there is no return given either by the OBR or within the five-year cycle in terms of debt, then politicians find it difficult to justify to the public, knowing that it is all up-front cost and no gain until well beyond when they are probably deposed and someone else is put in. There could be other reasons why long-term decisions of that sort are difficult for politicians, but are there ways that fiscal frameworks could not discourage people from taking long-term decisions that any Government will have to take in the national interest, and which involve up-front investment and long-term change?

Rupert Harrison: If politicians cannot make the case for long-term reforms, it is quite risky to put all the weight of that on an unelected body because it will start to bear too much weight. The OBR does get criticised for being judge and jury, and for policing government policy, and I think that is a risk to the OBR. You could imagine a future Government saying that the OBR has got too big for its boots and they are going to abolish it. That would be a massive retrograde step and, therefore, the OBR needs to be quite careful about staying in its box—not straying into controversial areas and doing its core function. Ultimately, politicians are the ones who need to build the case for difficult up-front reforms and long-term gain. Bodies such as the OBR can maybe help produce an evidence case and there is room for independent analysis, but really it should also be civil society. It should be independent commentators, academics and research. Putting a quango in charge of judging whether the Government’s climate policy is worth the short-term cost is very risky.

Q67 Lord Razzall: Moving on from what Rupert was saying earlier, many commentators have told us that the role of the OBR is effectively policing government policy, which you touched on in your last answer. I think I would be right that since the OBR was formed, whatever private disagreements have taken place, there has been no public disavowal by the Government of anything that it has said. Do you think there might be circumstances in which the Government should be brave enough to say they disagree and, if they did, what would be the effect on markets?

Simon French: Back in April, Scott Bessent pointed out that the CBO’s accounting standards in the US—I think this was his quote—was analogous to “Enron accounting”. He also went on to say he made a lot of money betting against the forecast of the CBO. On that day in April the Treasury market and the dollar market did not move, within the natural variance of the day. There was no noticeable market reaction to those comments and I thought, “I wonder what would happen if Chancellor Reeves were to make similar comments about the OBR”.

Lord Razzall: I am thinking about productivity.

Simon French: Absolutely, but I think that Sanjay put it correctly when he was talking about the foreign ownership and the hedge fund buyers of primary issuance of gilts. We do not have the exorbitant privilege that the United States has to be able to have our elected officials make those comments. So while some of us may egg the Chancellor on to do such a thing, I think that the market reaction would be pretty negative. You make those comments from a position of strength, and in Scott Bessent’s comments it is the strength of the economy which he is presiding over, not necessarily the strength of the economic policies he is putting together. I do not think that is a privilege accorded to this Government or any recent Governments.

Lord Razzall: Do you agree with that, Sanjay?

Sanjay Raja: I do. I would echo and add to that point, if I may. I think that the market will be fine if Rachel Reeves disagreed with the forecast but accepted it. She can publicly say that she thinks UK productivity growth should be higher, will be higher, and potentially the OBR is underestimating those forecasts and the growth potential of the country. I do not think that has any implications from a market perspective. However, to dismiss the forecast outright is when we are entering into dangerous territory.

I will say one thing to your earlier question on policing government policy. The OBR’s job is not to police policy. That may be happening indirectly through the fiscal headroom but those were the constraints put by government, effectively. That may also be the case now, coming to the earlier point about fiscal headrooms being very small compared to where they were 10 years ago. With the tight margins that we have, as we have seen this year, small changes can have meaningful impacts on those fiscal margins. That has become a much more important element of the recent focus, from a market perspective, on the public finances.

Rupert Harrison: I think that in the OBR legislation there is an ability for the Chancellor to reject the forecasts and—

Lord Razzall: It has never happened though, has it?

Rupert Harrison: It is in there as an important democratic safeguard that the Chancellor should not ultimately be locked in but, of course, the question is: would it be wise for a Chancellor to do that? That would depend enormously on the Chancellor’s own credibility. The question then would be: why is the Chancellor doing that? In this scenario the suspicion will be that it is to avoid a short-term difficult decision and get through the next six months. That would therefore be the negative signal that the markets would not tolerate.

As Simon said about Scott Bessent, and as Sanjay said, it is totally fine for the Chancellor to say, “I disagree with this OBR analysis”. That should not be taboo, as long as the Chancellor says, “Of course I will abide by the forecast and deliver it, but I think that we are going to overdeliver because the OBR is being too pessimistic”. That is totally fine. I do not think that markets would bat an eyelid at that.

Lord Razzall: Currently, productivity is the obvious one.

Rupert Harrison: Yes, and she said, “Well, I think that we can overdeliver”. That is fine. That is entirely within her rights.

On the perception of the OBR policing policy more generally, you have had the idea from both left and right that the OBR is a block to good policy. That has been the product of the OBR being a barrier to wishful thinking. On the right you had the Liz Truss Government, where they would have liked to be able to argue that tax cuts pay for themselves and did not need spending cuts to pay for them, and the OBR said, “That is not what the evidence suggests”. You now have it on the left of the Labour party, where people are saying, “We think that borrowing to invest in capital spending pays for itself and the returns will come through much quicker” and the OBR says, “That is not what the data suggests”. It is a cry of anguish at being presented with reality when you would much rather have some wishful thinking. I think that is a sign of the OBR working. It slightly overlaps with Lord Wood’s question earlier: if politicians want to make the argument for big reforms, they should make the argument for them. That is on them.

Q68 Baroness Liddell of Coatdyke: The OBR has been in the eye of the storm recently for non-economic reasons, but could the processes by which the OBR reports and communicates its analysis be improved? Frankly, to what extent do markets really care about probabilities and ranges, rather than the exactly forecast headroom?

Sanjay Raja: To start off with, change is a necessary investment for progress and I think the market appreciates that. We have this unhealthy obsession with the point estimates and, for the reasons that I mentioned, five years down the line that may not necessarily be true, but I think that has exposed itself to some consideration. The presentation and the inner focus that we have on these forecasts with their central projections lends itself to some questions and concerns. Is there a way to improve that? I think so. We can be thinking about different ways of presentation.

On your question about probability distributions, at the moment the market would probably scratch its head if that was to be the case. But would it learn and adapt? Yes, I think that is true. We have seen this time in and time out over the last 10 or 15 years. Look, the focus now is very much on that fiscal headroom; fine. If that changes and the Government/OBR say, “We are going to present this in a slightly different way”, perhaps by focusing on scenario analyses or more on a range of estimates that might give the Government a little more flexibility, appreciating some of the uncertainties around the central projections, that would not be necessarily taken awry by the market. However, it would have to be brought in and consulted on, and we must go through that process in the right way. It cannot be sprung upon the market immediately. If it was, I suspect we would have some negative reaction to it, but we should change the focus of that fiscal headroom, particularly given the concerns that the market itself appreciates about being too overtly sensitive to small changes in judgments by the OBR.

Simon French: The fund managers that I have spoken to since the Budget have largely said to me, “We recognise a doubling of the headroom” and that it materially reduces, in their view, the chance of the next fiscal event having to do remedial fiscal action. If you tack back to the probability distribution in the OBR report, that doubling of headroom only took the likelihood of achieving fiscal rules from 52% to 59%, which feels like quite a small percentage point change, given the market’s interpretation that this provides quite significantly more room for manoeuvre for the Government. If you are asking me directly if the OBR should underemphasise the probability distribution and, perhaps for public understanding, focus more on the totality of headroom in cash term—and probably benchmark that against the history of the last 15 years—that feels to me the more insightful way of getting high-quality information to the market, so that the market responds to and interprets it efficiently.

Baroness Liddell of Coatdyke: That is interesting. Thank you.

Rupert Harrison: It is interesting that both the Bank of England and potentially the OBR are experimenting at the moment with alternative scenarios. The Bank is in its response to the Bernanke review and the OBR has evolved its presentation of scenarios. In their different ways, they also try to present the idea about a range of probabilities. The OBR has always talked about meeting the fiscal rules in probabilistic terms, and that is helpful. Those different scenarios are useful to market participants and independent observers, because they draw out elements of the model: “What does this tell us about your off-central forecast if inflation remained higher for longer?” To Simon’s earlier point, there is nothing to stop the OBR saying, “What would the public finances look like if fuel duty revenues evolved in line with a constant freeze, as opposed to government policy?” Those scenarios can be useful.

In the end, though, the core task of the OBR that has been set by Parliament is to judge whether the Government are meeting their fiscal rules, so, particularly when headroom is small, it will come down to that binary comparison of the centre of the forecast versus zero. I do not think that any amount of ranges will change that. It just goes back to the earlier discussion: that is why having more headroom is just more useful for stability and policy.

Q69 Lord Burns: I have a general question first. Is there a viable road map for reducing the ratio of debt and GDP over the next five to 10 years if we are stuck with a growth rate of 1.5%? What is a realistic ambition for reducing the debt ratio? Does it matter?

Rupert Harrison: It clearly is doable. There are countries that have done and are doing it. The interesting thing is that while there are countries going in the wrong direction, such as the US, France and Belgium—three developed economies with clearly unsustainable public finances—if you look at the former periphery, the PIIGS from the eurozone crisis of Italy, Spain, Portugal and Ireland have gone a very long way towards running large primary surpluses and starting to run down debt. In countries where the risks have been presented to the electorate in very real terms, it is possible for politicians to make the case for running responsible policy and reducing debt over time.

In the UK we published some analysis in a Budget—I cannot remember which one; it might have been 2013-2014—showing that on average, over time, you need to reduce debt at a decent rate in normal times to avoid a permanent ratchet. The problem is that every 10 years or so you get hit by a shock that is worth about 10 percentage points of GDP, whether that is Covid or a global financial crisis. Therefore, it should still be a goal in normal times to reduce debt as a share of GDP, otherwise you are on a permanent upwards path because there will always be some shock. That is difficult politics, which in a slow-growth environment requires cutting spending or raising taxes in a structural way.

It is perfectly possible that we can get back to a position where that does happen. We have not had a full-blown fiscal crisis in the UK for quite a long time because Governments have either avoided it or changed their policies, as in 2022, but the public have had enough of the news around the Truss mini-Budget and those experiences. It has been a bit like a booster jab, so that the UK public are aware of the risks, whereas the public in France or the US are not aware of the risks and therefore it is impossible for politicians to make the arguments to take difficult decisions. However, it should be possible to do it.

Simon French: I think that there is a path. How politically tolerable that path would be is a very difficult question to answer. Over the course of this Parliament, I think public spending is expected to be about 44.5% of GDP. That is less than two percentage points short of the all-time non-crisis high of 1976, which was not a great year for the UK economy. You are in a situation where, on the balance of probability, public spending and public spending reductions will be the mechanism by which you get debt to GDP down.

There are potentially three angles to do that. The first is the ongoing second Pensions Commission. Will that provide a bipartisan, or plural partisan, approach going into the next election of saying it was the right thing to address pensioner poverty 15 years ago—by then it will be almost 20 years ago—through the triple lock, but that there is always something of a seesaw between working-age poverty and pensioner poverty, so has that gone too far and is this the mechanism? That is one route but it will need a very skilful Pensions Commission report and some alignment of politics.

The second angle to mention is energy policy. While the Government are on a credible path towards lower-cost energy on a multi-decade view, there is little sign of a concerted supply-side response in the window you have just presented that could generate a higher tax base and reduce the GDP deflator, as I think it should, to have a downward impact on domestic inflation. Again, the current tax regime on North Sea oil and gas and its licensing regime does not suggest that is a political path, but that may change.

The big one in terms of public spending has to be—this comes back to the debate on the productivity assumption—whether AI will have a transformative impact on the health budget. Of course, the health budget, as I do not need to tell you, dwarfs all others. If there is even a small impact on the National Health Service and health productivity that could change, obviously on a compounding basis, the long-term fiscal position but even within the five-year horizon it could start to put downward pressure on debt to GDP.

Sanjay Raja: I would probably take a slightly more pessimistic view than Rupert. I think that we may end up having to live with and manage higher debt levels. The public appetite for austerity and spending cuts is very limited. You can take two routes to bring down debt, at least as a share of GDP. One is to cut spending quite strongly and aggressively, as we had not so long ago in the last decade, or alternatively you hope and pray that growth will come and rescue the day. Now, Simon has mentioned quite a few things. AI could be that saving grace, potentially. I am not quite sure; the jury is out on that. Whether or not it has the transformative effect of raising total factor productivity by 20, 30 or 40 basis points is very unclear at this stage, but my personal view is that we will have to learn to live and manage with these debt levels, given some of the pressures that we are seeing.

Ageing demographics is one major part of that. The size of the welfare bill has obviously been growing and potentially will increase in cash terms, at the very least. If you look at defence spending and the net- zero transition, all these things add upward pressure to the public finances. It is very difficult in my mind to envisage a world in the next five or 10 years where that debt to GDP number comes down drastically.

The other thing I would say is that with almost every Government who we have had in the last few years, debt levels rise and then suddenly come down in the last fourth or fifth year of the forecast horizon when those fiscal rules bind. It just adds to some of the questions that we have, and the questions that the market has to deal with in terms of how much debt it can absorb at the end of the day.

Q70 Lord Burns: That leads me on to the question of whether there should be any changes to the fiscal framework and the fiscal mandate. If we are facing this very tough prospect ahead, there have been suggestions already that maybe one should look at a shorter time period for some of the fiscal rules. In terms of looking at the whole thing from when it was set up 15 years ago, is this an occasion, given some of the tensions that there have been over this year, to ask whether there are any changes that are needed?

Simon French: I do not think that we have covered it in expressing our views and mine may be an outlier to the other two witnesses. My perception of how academic economists perceive it is that a single fiscal forecast a year, and a single binding test on the Government of whether they have achieved their fiscal rules, has been in the majority of cases criticised as a rolling back of transparency. I think you have assembled the three of us to get the market’s view. The market’s view is unanimous that less is more in terms of deployment of capital and the confidence of the household sector to undertake big-ticket item expenditure. If there is a reduction in the periodicity of that from six months to 12 months, I feel that would be constructive for economic growth, given what we know about business investment and the relatively high savings rate of the UK household sector.

You can certainly construct an academic argument, although hard to prove empirically, that some of that is because of this cycle and quite high repetition cycle. I would be strongly supportive of the Chancellor having a single fiscal event. The problem, of course, is that the Charter of Budget Responsibility requests two forecasts. We will all do it: we will mark to market the second forecast against the fiscal rules. I am not sure what you do but I would advocate the Government revisit that and change the charter of fiscal responsibility to one a year because there are economic growth benefits. That is a personal view.

Rupert Harrison: Is the question: should we totally rethink the whole framework? Maybe we do not need fiscal rules but need a different approach?

Lord Burns: No, I am thinking more of ways of modifying them and how we can get greater assurance that we will not find ourselves in this position of an exploding debt ratio.

Rupert Harrison: I think the current fiscal rules are the loosest fiscal rules that we have ever had. That is quite deliberate, because this is a Government who at the margin want to borrow more for capital investment. The market has just about tolerated that but we are getting to the limits of it, because markets now are very sensitive to bad news. On balance, if you are worried about the long-term debt trajectory we should be thinking about a slightly tighter set of rules. We should be thinking about debt falling not just in the final year of the forecast but in normal times. When you are not in a recessionary environment, we should probably have debt falling as a share of GDP, because we know that there will be shocks that will increase it again. It is difficult to get from here to there because you have loose policy and it is painful to tighten it.

Sanjay Raja: I have a few points. I may have a slightly different view from Rupert on this, which is that while our debt secondary rule may be quite loose at the moment, that primary stability rule is quite tight in many ways getting to a current budget balance. I think we have not done it sustainably since the previous Labour Government in the late 1990s or early 2000s. It is not just a very stringent fiscal rule but, from a time horizon, it is not baked into the fifth year of the forecast horizon. At the very least, you may say that the Chancellor has brought that forward to the third year of the forecast horizon, which makes it slightly more challenging at least in terms of achieving a current budget balance, which we have not done very often.

On the fiscal rule specifically, there is a lot of empirical evidence here. The question that we would have to ask ourselves, as economists and from a market perspective, is the counterfactual: have fiscal rules delivered relative to not having fiscal rules? There is quite a bit of empirical evidence that well-designed fiscal rules with numerical targets have seen reductions in borrowing and debt relative to those countries or jurisdictions that have lacked appropriate fiscal rules. Well-defined fiscal rules combined with transparent reporting, such as what we have with the OBR, has also been associated with lower sovereign yields, so in some ways the empirical evidence has justified the existence of fiscal rules.

On Simon’s last point about having one forecast a year, I think he will be surprised to find that I had an op-ed earlier this year talking about just that and advocating for one fiscal forecast. The motivation behind that, ultimately, was the fact that we have a Chancellor who has talked about one fiscal Budget, so having two fiscal events and two sets of forecasts to me felt at odds with that equation. In many ways, especially given how tight the fiscal headroom has been, my challenge has been that small changes such as quick adjustments on gilt yields that may or may not have anything to do with the United Kingdom—they could be cross-market, for example, coming from across the pond—can have a course-correcting action for the Chancellor, not five or six months after the Chancellor has delivered a Budget. In many ways it added a bit more volatility to the process—more noise to the gilt market—so we would have to go into the next fiscal year and, before it began, we were already thinking about course correcting and fine-tuning policy because of different adjustments that have come through.

Rupert Harrison: Just briefly on that issue, I think that moving to one forecast a year would be a retrograde step. The UK would stand out internationally as one of the few countries to have only one forecast. I think that the IMF came out saying that would be too far. The compromise where the Chancellor seems to be heading of having two forecasts a year but being judged against the fiscal rules in only one of them probably is fine. In the off-cycle forecast, everyone will see whether the Chancellor is meeting her fiscal rules and she can choose how to deal with that politically, but it may be that at the margin it reduces the six-monthly cycle. Only one forecast a year would leave too much room between forecasts for things to change.

Sanjay Raja: If I may add this quickly, based on Rupert’s point, which is a fair point and a fair challenge, given the international comparisons that we have, one way to get around it is by defining it as a spring forecast update, where it does not look like the standard EFO that we get and we can talk more about the risks, the sensitivities and so on. It is a much slimmer document, as opposed to the 200-odd pages plus appendices that we get. There is a compromise there that can be achieved and which would satisfy markets and international organisations.

Q71 Lord Burns: Finally, on the wider budget process, clearly there has been a lot of tension this time around. Some of it may be to do with the fact that the whole thing takes place at arm’s length and then there is a delay between the forecast going to the Treasury and the Treasury’s response. Then we saw the incident of having the letter with all the dates and what they were forecasting. Should there be more openness about all this or should we seek to get back to a world where it is closed down, so these discussions take place in private and we then have a Budget at the end of that process? It has been a bit messy this time.

Rupert Harrison: It certainly used to be possible with the OBR to have a Budget process that was much less leaky. In the end the political teams, both Ministers and special advisers, seem to have progressively lost the belief in Budget secrecy. It certainly was possible, even since 2010, to have a Budget process that was much more orderly, so I think that is about the politics. On things that are market-sensitive, you do not want to have too much of a public discussion. There is certainly scope—it is a huge topic—for how the Budget and the tax-making process itself could be improved. Previous reports and Chancellors have talked about more pre-consultation on tax changes, longer road maps for taxes, more time for engagement and less rushed legislation. That is a massive agenda where there is huge room for improvement, but on the Budget secrecy process this was a clear political failure that can be improved.

Simon French: We mentioned earlier in the hearing that the lessons from the mini-Budget have still not been fully learnt. There was a lot going on over that period. Was the market responding to the dislocation in UK assets or to the sheer size of the energy bailout package? Was it responding to LDI? Was it responding to unanticipated tax changes announced, with more promised from the then Chancellor?

I am not sure anybody has drawn a definitive conclusion—I certainly have not—but one of the conclusions you may well draw comes from another thing that happened over that period, which was the sacking of the Treasury Permanent Secretary, the negative briefing by a former Prime Minister against Andrew Bailey and the Bank of England, and then, of course, the OBR not scoring the mini-Budget. Is the lesson learnt from the political teams that you actually need to give the market quite a lot of visibility of what is coming, because if you do not there is a risk of getting the market dislocation that we saw in 2022? It is one of the potential suspects. They did not see the fiscal policy changes coming and therefore you got volatility, which started to feed off itself in the case of LDI. That is possibly the case for the defence of how the last Budget round was being handled.

The case for the prosecution would say that on 3 September, when the Chancellor announced the Budget, if she was going to frame it in terms of supply-side stocktake and difficult decisions, you do it then and have a period of official silence, well enforced at Treasury level, between then and Budget day. That would be more of a secret, private configuration.

Sanjay Raja: I think the equilibrium that we have reached is suboptimal. The budgetary process has been far too leaky than we had in the past, as Simon and Rupert have mentioned. Either we have a very full, open and transparent approach, and then maybe you reduce some of the uncertainty, volatility and speculation that comes with that, or we have a much more closed process. This year, just to emphasise a point that Simon made, a protracted budgetary process fuels speculation and uncertainty, and that has implications for the real economy. We can see this in consumption. We can see this in housing activity and in business investment.

If you look at the ONS’s preliminary estimates for business investment this year, in Q3 over the summer, where Budget uncertainty hit its peak, it contracted for a second straight quarter, and that has implications. We need to deal with that in some way. Perhaps structured pre-Budget engagement with relevant stakeholders could help, where we know that things are happening in a certain order, as could engagement with corporates, markets, trade unions, think tanks et cetera. Perhaps it takes some of the surprise and speculative elements out of that equation. That is one part of a potential solution. I would not personally be opposed to that.

You have mentioned the point about the dates. This is the first time in my career where I have had investors call me up and say, “This is the date that the Treasury is getting a forecast update from the OBR. What do you think will happen?” Beats me. I would not and should not know what is happening between the Treasury and the OBR, but this was an unusual circumstance where investors were hyper-focused on those dates and trying to figure out or pencil in where that elusive fiscal hole was.

One part of that solution which I can see as a compromise, perhaps to try to break some of that speculative behaviour, is that at the very end of the economic forecast there is some update on where that fiscal hole could end up being. It anchors market expectations—I think this is what Simon was alluding to—because you do not want to throw a bomb at the markets and say, “This is a huge fiscal consolidation exercise”, when it is not. Expectations can adjust accordingly. There is a middle ground that needs to be taken. I am not quite sure where that middle ground is; there should be some consultation and experimentation with that. The structure that we have at the moment, if I may be as bold as to say, just does not lend itself to economic sentiment and animal spirits.

The Chair: We have a couple of final follow-up questions, but please do not feel that all three of you have to answer them all. I will start with Lord Blackwell.

Q72 Lord Blackwell: Going back to the fiscal framework, I want to ask about the specific target. The objective of this whole process is both to reassure the markets that the Government are not going to explode the issuance of government debt and to give the Chancellor a way of controlling spending departments within some framework. The measure of one year’s deficit or surplus five years out is a pretty imperfect way of doing that because, as you have all said, it is a very volatile number—the difference between two very big numbers—it is a long way out and forecasting is a mug’s game anyway. If the objective is to reassure everyone that government debt, if not falling, is at least not going to go up significantly, absent a major shock, would it not be simpler to set the target in terms of saying that government debt as a percentage of GDP, three years or four years out, whatever your timeframe is, is being targeted so that debt should be the same or X per cent, rather than doing it in terms of one year’s flow?

Rupert Harrison: You highlight a lot of the problems with a five-year forecast. I think that we all agree it should be shorter. You also highlight, rightly, that one of the major functions of fiscal rules is that internal power it gives the Chancellor to not constantly be giving in to additional demands. I think that it does not make a huge amount of difference—I probably need to think this through—whether you are targeting the current Budget balance or a total Budget balance or debt. We have the two at the moment because the current Budget balance excludes capital spending, so therefore you need a debt rule to ensure that capital spending does not add too much to debt. You could absolutely construct a debt rule. It would be quite similar to what I said earlier about having a “debt should be falling in normal times” rule.

I say this given that the Government I was part of had that kind of rule. It is not ideal to have a rule that is structured as it should be falling in the fifth year because that just gives so much leeway as to what happens. It is so easy for the Government to game that year by moving capital expenditure in and out of that year. That is not an ideal rule and, as you say, more of a level or a path of debt might be a better answer.

Lord Blackwell: It has the advantage that it is cumulative rather than all depending on the last year, as the big numbers are volatile.

Rupert Harrison: Yes. You could make that argument.

Sanjay Raja: The one issue I would have with debt targeting specifically is that often we do not know what the starting point is because of revisions et cetera. In many ways, a Government may be making a policy on where they want debt or debt to GDP to go, but oftentimes they may not know where that starting point is with any precision, given some of the volatile revisions that we get from one fiscal year to the other.

Another thing that I will quickly throw into that mix is the question of headroom. I do not want to belabour this point; it is important, but it is almost in the eye of the beholder. If I can take you back to 26 November when we had the unfortunate leaks coming out from the OBR, and when Reuters and Bloomberg had revealed what that fiscal headroom was, the market did not rally on that. The market actually sold off on that, because what it was seeing was a very back-loaded consolidation. It was not until it started to look at the gilt remit, the cash borrowing, that the market started to rally significantly. I think that is the ultimate litmus test for any fiscal event.

It is not so much about this arbitrary Budget headroom number because we know that can come and go. It can vanish in an instant. The one thing that I have been saying consistently is that the litmus test for any Budget will be the cumulative increase in the gross financing remit for the Government. On that number—I appreciate this sounds a handful to say—it surprised massively to the downside so that over a four-year period, between fiscal years 2025-26 and 2029-30, that cumulative increase was £6 billion. We were expecting it to be about £22 billion. I think we had one of the larger market surveys taken, to get the pulse of the market, and the expectation was between £25 billion to £50 billion. Once we saw the Debt Management Office publish the first big surprise on the gilt remit, i.e. £4 billion or just under £5 billion, as opposed to the £10 billion expectation, then markets started to realise that there were long options cancelled, there was effective debt management taking place but also that cash borrowing requirement has not changed massively, that was the key litmus test that allowed the market to rally through the day.

The Chair: We have three more questions in about 15 minutes so we have to crack through them. We will have Baroness Wolf first.

Q73 Baroness Wolf of Dulwich: Mine is a very quick and rather secondary question. Would there be any value in asking the OBR to do more explicit retrospective analysis of where it got things wrong and why things happened differently, or would it be only academics who ever read it or took any notice?

Rupert Harrison: It does its forecast evaluation report, which I think is very good.

Baroness Wolf of Dulwich: Yes, but would it be better if it was more of an occasion, maybe? I do not know, it might not be.

Rupert Harrison: I do not know. That is already quite a high level of introspection and transparency, relative to other jurisdictions.

Simon French: I would agree. I think that the OBR is pretty good without us looking at the evaluation of how much it thought the energy profits levy would raise from North Sea oil and gas. Although there were very considerable forecasting errors, this goes back to something we discussed about half an hour ago: it was very much derived on the conditional assumption of the future gas curves. It is hard to criticise a forecaster for getting it wrong when you are taking conditional assumptions from a market where billions of dollars’ worth of contracts are traded. I think that its evaluation is pretty good. You would want to strengthen it only if you think there is insufficient scrutiny of where policy has been delivered poorly and want to bring pressure to bear, but that has to be the function of the core Treasury Civil Service. That is to Rupert’s point earlier about the overreach of the OBR.

Sanjay Raja: My very quick answer is yes to both. It would be nice to have but, other than the three of us individuals in this room and some other individuals who would read it, I am not sure it would get a lot of press time.

Q74 Lord Petitgas: I have a more general question about markets. I was fascinated to hear you because I have formed the impression now that we have a good system in place, that the UK is not doing badly versus other markets and that the markets, ironically, have a much more short-term focus than perhaps I had expected. We are certainly more interested in the long term, certainly in this committee, and thinking about demographics. Yet I am wrestling a bit with something that is in the OBR report and in the Budget: the real return on investment in the UK has fallen to low levels, at the same time as our cost of capital is the highest in the G7. Maybe there is another that is as high as us or even higher, in France. Is there something there that is not right, beyond the short-term vagaries of having reasonable headroom or not, which we should worry about?

Simon French: Inflation. UK inflation has averaged 3% since 2010. There is a 2% target. The Bank of England’s record on that since 1997 was very decent; there was 1.94% inflation pre-2010. That inflation premium across the gilt curve, which by the way extends into the corporate curve cost of capital in both debt capital markets and UK equity markets, is pretty apparent. My contention on what others have called the moron premium—I am rather jealous; I would have liked to have come up with that myself but it is not mine—is, in my view, that it is less a concern about debt sustainability in the long term but actually about the near-term outlook for inflation and therefore the potential for supernormal profits of the corporate sector, which crystallises in that pricing across almost all asset classes that are domestically focused.

Rupert Harrison: I tend to disagree on inflation. I think that is quite an unfair comparison, because you are using a period where you just had a massive supply shock that created massive inflation around the world, and the Bank of England managed that broadly okay. There is an inflation premium in the UK curve, but our view at PIMCO is that it will get priced out because we think that concern is quite backward looking. We have had sticky inflation. It looks quite likely now that it will be falling very rapidly; wages are falling rapidly and we think that the Bank will cut rates. But that is what markets are for: to take opposing views and put money behind those views.

To your argument, I think that markets are focused on the R minus G debate, which is: how sustainable is UK debt, given that we are paying quite high interest rates while our growth rate and return on investment is relatively low? That definitely contributes, along with the experience of the Truss episode, to the fact that markets seem to treat the UK now as “guilty until proven innocent”, whereas for a long time it was the other way around. We had a very strong reputation. Since 2022 and now with concerns around slow growth and stubbornly high spending, the UK has to work a bit harder to prove itself to markets, and that comes at a cost.

Sanjay Raja: I will very carefully tread between Simon and Rupert. I certainly see the arguments that Simon has made and agree with what Rupert is saying on inflation and the supply side shock that we had. But I can also tell you that every investor I talk to who is not on these shores, particularly in Dubai, New York, Miami et cetera, will say that the UK has a very high inflation rate. That may be one of the misconceptions we have. It is not helped by indexed administrative costs et cetera. Nevertheless, that is a perception, rightly or wrongly, that many investors may have, which potentially raises the cost of capital.

The second thing to add, which I do not think we have talked about yet so I will throw it in, is the twin deficit problem. The UK is not a net saver. It does not have that domestic investor base. As Rupert mentioned at the start, we run large, sticky deficits but we also have a very large current account deficit. We buy a lot from international markets et cetera, which just makes us a little more vulnerable to fiscal risks. That is probably one of the reasons why we had a bit of a premium when it comes to UK gilt pricing.

The Chair: Lord Liddle has the last question.

Q75 Lord Liddle: Thank you for a very stimulating session. It was really good. In my simplistic political mind, the solution to high debt is to raise the rate of growth. The question is: can you raise the rate of growth through a credible increase in public spending, which the markets are willing to bear? For instance, if we did a crash programme over five years of investing in skills, with a house-building crash programme focused on Oxford, Cambridge and the potentially growing areas of the economy, and if we threw money at growing SMEs—a kind of help to buy for SMEs with potential—if the Government decided to do all of that, would it be regarded as fiscally responsible?

Rupert Harrison: No.

Simon French: No. We agree.

Rupert Harrison: If they tried to do that and not show how they were going to pay for it, and if they tried to apply multipliers to those investments that were not backed by evidence or by the OBR, then that would be a left-wing version of the Truss mini-Budget and the market would worry about that a lot. This Government have decided to increase capital investment quite a lot. The OBR has a multiplier on that in terms of increases in productivity. It has published very good charts about that. They rightly show that it takes a long time and, in the meantime—

Lord Liddle: Long-term capital investment.

Rupert Harrison: Exactly. It takes 20 or 30 years before you really get the bang for buck and in the meantime, you have to pay for it. That again is the value that the OBR brings. This is where we get more into politics. More generally, this crisis of growth is common across many western economies, but there is one economy that really stands out for having had much better performance. That is the United States, which is not characterised by higher public spending or higher taxes; it is the reverse.

Simon French: You cannot draw a line and say all new public spending is tone deaf and lacks memory of what has come before. If you look at HS2, if you look at Hinkley or the Lower Thames Crossing, there is a reason why the cost of capital for the UK is elevated. When benchmarked against equivalent infrastructure projects around the world, we appear as a country to establish quite luxury beliefs around how we want to deliver those projects, which elevates the cost of capital. You may also want to do that and to produce a big demand-side stimulus at a time when international investors—again, our market insight will tell them this—would say: “You have had Brexit, you’ve had a transition in your energy costs to be the most expensive in the world, and you’ve added significant cost to the labour market”. Those are quite suppressing supply-side influences, so if you then want to add in a big demand stimulus financed by the public sector, there will be an enhanced inflation premium put on top of that.

Sanjay Raja: Very quickly, it may be my turn to sit at odds with Rupert and Simon on this. I want to buy into and believe everything that Rupert said as an economist, because I think that is the right way of looking at it. However, from a market perspective the precedent that we have seen over the last year, especially when the Chancellor introduced a substantial increase in public sector net investment, which will likely have strong high multipliers and a return, meant that the market effectively, at least from the conversations that we were having, focused on one thing. It was the £175 billion cumulative increase on issuance. Because of execution risk and everything else in between that we have talked about, it almost discounted what that means. It is almost like we need to see the growth for the markets to believe it, which makes it quite difficult to engineer that sort of increase in spending and borrowing.

The Chair: Great. Thank you so much. That is fascinating and we have really enjoyed the insights from your perspectives. We really appreciate your time. Thank you so much for coming. With that, the meeting is adjourned.