The living standards cost of the OBR’s newfound productivity pessimism

Published on Public Finances and the Economy

Rumours of attempts within the Cabinet to remove Philip Hammond may or may not be wide of the mark. But given the recent steady flow of disappointing economic data, the Chancellor could be forgiven for wanting to walk before he’s pushed. Last week’s PMI data and today’s short-term indicators from the ONS both suggested that growth will remain subdued in the third quarter of the year. But the worst news comes not in the form of new figures, but in the guise of a pre-announced change in opinion within the OBR.

As trailed by Chris Giles last week, today’s Forecast Evaluation Report is very clear about the OBR’s intention to downgrade its projections for productivity growth at next month’s Budget. The report doesn’t specify quite what the new forecasts will look like, but it explicitly states that it expects to lower its cumulative forecast “significantly over the next five years”.

This decision is based on the fact that economic reality has consistently failed to match the fiscal watchdog’s expectations. As the chart below shows, the OBR has projected a pick-up in productivity growth time and time again, only for the subsequent data to show that UK output per hour remains stubbornly fixed at pre-crisis levels.

The OBR has long signalled that its productivity forecast is both the most important and most uncertain element of each of its Outlook publications. And it has revised down its expectations twice before, with trend productivity growth being lowered in both the March 2016 and November 2016 reports. The first of these revisions reflected an acknowledgement that ongoing stagnation made it likely that at least some of the post-crisis performance represented a reduction in trend productivity growth. The second reflected expectations of a near-term Brexit effect on investment resulting from the uncertainty generated by the referendum result.

But the revision it has signalled for next month looks like being much more significant than anything that has gone before. It reflects not the arrival of any new facts or any re-assessment of the impact of Brexit, but rather a revised interpretation of what we’ve already seen:

It is important to emphasise that whatever revision we make it will not have been driven by the most recent quarters of data – nor by a precise calculation of the likely impact of Brexit – but by looking again at the weakness of productivity growth over the whole post-crisis period and at the evidence that this is at least in part a persistent global phenomenon. As such, the change would relate entirely to our assessment of underlying prospects for potential productivity growth.

The exceptionally weak level of productivity growth over the past decade is brought into sharp relief if we take a longer-term view. As the next chart shows, average growth over the last ten years is lower than any period since 1893. Faced with such a backdrop, it is perhaps unsurprising that the OBR has become more pessimistic.

But what does all this mean? In one sense of course, nothing has changed: we’re dealing with changes in projections here rather than changes in actual data. But, as Chris’s excellent article pointed out, these new projections will be very big news indeed for public finance forecasts. Lower projected productivity growth would be expected to feed directly through to lower economic growth, thereby reducing the revenues received by the Exchequer and raising annual borrowing. The suggestion is that the new projections could wipe out as much as two-thirds of the £26 billion fiscal headroom the Chancellor was previously estimated to have.

The new projections will matter too for living standards. Again they won’t directly change what actually happens to wages and incomes, but a downgrading of productivity growth will lower expectations for the future and so will heighten the political pressure faced by the Chancellor and his colleagues.

We can’t guess at what scale of reduction we’re looking at just yet (the report states that the OBR continues to expect some recovery in productivity growth). Nor can we be precise about the extent to which any reduction in productivity growth will feed through to pay. The OBR will of course revisit all of its projections next month, and today’s report notes that the revised view of future productivity growth will be partially – though by no means entirely – offset by a lowering of its expectation for the equilibrium unemployment rate and for a slower reduction in average hours. Nevertheless, the productivity changes are still likely to produce very significant reductions in earnings forecasts and it’s worth reflecting on how much of a difference any shift in the OBR’s numbers might mean.

In the absence of any hard numbers, we set out a very simplified thought experiment below in which we consider the impact of lower productivity growth on average earnings. In a report published last year, the OBR said that it assumes productivity paths are reflected one-for-one in average earnings.

There’s good reason to believe this won’t be the case going forward, given their new assumptions about employment. Nonetheless, the feed through into wages would still be huge. This slower earnings growth, outlined below, comes on top of a sharper than expected fall in earnings over recent months, meaning that both the starting point and the future pace of recovery are lower than previously anticipated.

It’s worth noting that average earnings were on course to remain below their pre-crisis peak at the start of 2022 even under the March projections. Applying the – arbitrary but illustrative – assumption of a halving of future growth leaves average earnings close to £1,000 below the 2007 level. That would represent a wage squeeze of at least 15 years, with full recovery unlikely to arrive until well into the next decade.

For now these numbers are made up. And even when we get the final OBR assessment at next month’s Budget we should remember that projections have a habit of being proved wrong. But the exercise above serves as a reminder of just how central productivity is. Political futures can be as uncertain as economic ones, but fixing Britain’s productivity disaster must be priority number one for whoever has stewardship of the economy in the coming years.