OBR's supply pessimism could be the ruin of this government

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Next (Berlin: NXG.BE - news) week, the Chancellor will pronounce on how far his fiscal rules need to be redefined - or reinforced with more fiscal tightening. How much slack there is in the economy will be critical. If there is a good deal then, as soon as the economy recovers, much of the fiscal problem will disappear like melting snow.

By contrast, if there is none, then only austerity, delivered now or later, can reduce the deficit. Moreover, if you think that there is no slack then there is no point in the Government or the Bank of England trying to boost aggregate demand. Even if they succeed, the only effect would be to boost inflation.

You might think that the hope then would be for a spontaneous recovery in the private sector. But sauce for the goose is also sauce for the gander. If there is no spare capacity to meet extra demand created by policy then neither is there capacity to meet extra demand emerging spontaneously in the private sector.

The Office for Budget Responsibility (OBR) takes a pretty pessimistic view. It puts the amount of slack at only 2.5pc of GDP. Yet output is still 3pc below its 2008 peak, and supply capacity normally grows by about 2.5pc per annum. If this had happened over the last few years then output would now be about 13pc below capacity.

The pessimistic case is supported by five main arguments none of which I find very convincing. First (OTC BB: FSTC.OB - news) , at the 2008 peak, GDP was boosted by high value-added City activity which has since fallen back and cannot be restored. Resources (Euronext: ERS.NX - news) can only be re-employed in much lower value-added activities. There is clearly something in this but not much. For the recorded downturn in output is across most sectors.

Second, output may be higher than the official GDP figures suggest. Yet there would have to be a mammoth under-recording to explain the entire gap. And if GDP is in reality much higher then why are tax receipts so subdued?

Third, at its peak, the economy was overheating and its subsequent slip back just returns it to a normal level of capacity utilisation. Yet before 2008, growth had hardly been breakneck and both price and pay inflation were modest.

Fourth, plant has been scrapped or mothballed, partly because the changes brought by the crisis have rendered it unproductive, while the unemployed have lost skills. Yet there is no evidence for scrapping on this scale, while one of the success stories of the recession has been that so many workers have remained in employment.

Fifth, the recent appallingly low productivity figures are a direct effect of the financial crisis and represent “the new normal”. Yet productivity can also respond to aggregate demand. In many activities, the notion of firms readily being able to shed employees as demand turns down is about as old-fashioned as rows of cloth-capped identikit worker drones. Much of the workforce is effectively not a variable cost but a fixed one. As people have become more skilled and economic processes more inter-related this effect should have grown in importance.

This links up with the apparently most telling bit of evidence, namely the fact that inflation has recently been so stubbornly high. If there are so many spare resources, the supply pessimists ask, then why has inflation not plunged? Some of the answer is that extraneous factors such as the depreciation of sterling, the VAT rise and higher commodity prices have kept it up.

But there is something more fundamental. In many businesses, as output falls, unit costs do not fall. They may even rise. Even marginal costs may not fall. In economist-speak, this amounts to the heretical idea, which I advanced some years ago that, over wide stretches of output, the supply curve is broadly flat, or may even slope downwards. In that case, the relationship between unemployment, or output, and inflation (i.e. the Phillips Curve) may be pretty flat too. This would mean that as the economy contracted, inflation would not fall by much, if at all. It would be stuck at its inherited level, plus or minus the influence from various one-offs and extraneous factors. The flipside is that as and when demand picks up again then inflation need not rise.

Supply pessimism is one of the most dangerous sets of beliefs known to man. Unfortunately, just as in the 1930s, it is alive and well and living in Whitehall and Westminster. What makes it especially pernicious is that, since it justifies policy inertia on measures to boost demand, it may produce results which are self-fulfilling.

All economists get things badly wrong sometimes, including yours truly. But few make mistakes as influential as the OBR’s. Its (Euronext: ALITS.NX - news) supply pessimism could be the ruin of this Government. The Chancellor should place no store by it.

You probably never thought that you would read these words from me, but on the aggregate supply issue I am decidedly an optimist.

Roger Bootle is managing director of Capital Economics.