Sector balances, macroprudential policy and the UK economy

A week ago the Office for Budget Responsibility published its Economic and Fiscal Outlook alongside the Autumn Statement. And for a change most the reaction and analysis focused on the fiscal forecast rather than its economic outlook.

On one level that’s completely understandable — the OBR found a cumulative £27bn of additional fiscal space for the Chancellor despite little change in the headline economic numbers. Naturally, that merited attention.

But that doesn’t mean that the economic forecasts aren’t worth a closer look. Especially after the Bank of England published its Financial Stability Report yesterday and signaled that a tightening of macroprudential policy (the Bank’s new(ish) toolkit of measures to control credit growth and prevent instability) is on the way .

Because the more I look at the OBR numbers, the more I struggle to see how the Bank of England could allow them to happen whilst sticking to its current remit.

It’s a forecast of a changing remit or a policy failure.

This time last year, I wrote that I expected UK monetary policy to remain easy but macroprudential policy interventions to step up.

In theory, this should allow the Bank to prevent the formation of dangerous bubbles whilst not hitting the existing stock of loans with a sudden rate shock. In theory anyway and for what it’s worth I think the biggest risk to macro-pru succeeding in the UK would be if the Bank attempted to use it as a substitute for, rather than a complement to, regular monetary policy.

In effect we’d have cheap money but not necessarily easy credit.

That still feels about right. Whilst rates will start to rise in 2016 we’re heading for circa 2.5% not 5% in the next few years. But macro-pru policy could mean that the “new” 2.5% feels a lot tighter than the “old” 2.5%.

There is a long discussion of monetary policy in the OBR report but there is no mention of macroprudential policy. And, if one turns to their forecasts for sectoral balances (the net borrowing or lending position of households, firms, government and foreigners), that might prove to be a problem.

Before proceeding there are a couple of important caveats to bear in mind.

First, the OBR forecasts of sector balances aren’t really a forecast as such — they’re a residual, they are best thought of as a way of making the other numbers add up.

To ever-so-slightly-over-simplify, pretty much every OBR forecast that shows decent economic growth has also seen a big rise in household debt as part of that. And those debt forecast have “disappointed” just as growth did from circa 2011 to 2013.

The second caveat is perhaps more important.

I’m suspicious of attempts to divine economic forecasts from sectoral balances. For example an argument, the David Graeber that a public budget surplus will necessarily lead to a large build up household debt and hence a 2008-style crisis seems too reductive to me.

But I do think that balance sheets matter and that looking at the stock of assets and liabilities on household, firm, financial sector and government accounts is just as important as the usual focus on the flow.

As I’ve said more than once, the best paper the Bank of England has published in recent years was this one.

The years leading up to the financial crisis are widely acclaimed as a period of remarkable, if not unprecedented, stability in the global economy. From a perspective that focuses on the value and volume of gross domestic product, that assessment is valid. The world’s major economies enjoyed a sustained period of growth. Inflation was low and stable. But from a perspective that focuses on the value of financial assets and on the volume of market activity, this period was anything but stable. The past decade has borne witness to sharp swings in asset prices and a large expansion in credit and balance sheets.

That kind of analysis means taking sectoral balances seriously, even if not imbuing them with too much in the way of predictive power.

In short, I think sectoral balance analysis can prove a forecast false even if it can’t prove one true.

And it alerts people to the assumptions underlying any projected path. In which spirit, the current balances (expressed as a % of GDP) implied in the OBR numbers are, erm, “interesting”.

It sees households running a persistent deficit of 2% of GDP for the foreseeable future. A deeper deficit than that which came before the 2008 crisis (which was itself historically unusual) and a deficit that is essentially funded by borrowing from overseas.

Jo Michell (and you should really read this post in full) has done an excellent job of showing how the analysis of sectoral balances can be very useful indeed.

This chart in particular is pretty eye-catching.

And as Jo notes, the OBR themselves (with their typical openness) have highlighted the risks to their forecast.

Available historical data suggest that this persistent and relatively large household deficit would be unprecedented. This may be consistent with the unprecedented scale of the ongoing fiscal consolidation and market expectations for monetary policy to remain extremely accommodative over the next five years, but it also illustrates how the adjustment to fiscal consolidation assumed in our central forecast is subject to considerable uncertainty. (OBR, page 81, Jo’s emphasis)

Which takes me back to where I began, would the Bank of England really allow households to take advantage of the fact that monetary policy may “remain extremely accommodative over the next five years”?

It might do.

But I really don’t see how that would be consistent with its financial stability mandate or how it fits with the move towards using macroprudential tools that the Bank is signalling.

I suspect future editions of the OBR’s forecasts will be forced to grapple more with macroprudential policy.