High household debt and extreme house prices threaten the UK economy and the Chancellor won’t balance his budget by 2019/20, says a new economic forecast from the Centre for Business Research – Winter 2015

High household debt and extreme house prices threaten the UK economy and the Chancellor won’t balance his budget by 2019/20, says a new economic forecast from the Centre for Business Research – Winter 2015

A new forecast for the UK economy – Winter 2015 – has been launched by the CBR. The authors of the report are Dr Graham Gudgin and Ken Coutts, of the Centre for Business Research, University of Cambridge; and Professor Neil Gibson and Jordan Buchanan, of the Economic Policy Centre, Ulster Business School, the Ulster University, Belfast.

This forecast is generated by a newly developed model in the Keynesian tradition which provides an alternative to the model of the Office for Budget Responsibility (OBR). The main points in the forecast are:

  • GDP is forecast to grow at 2.2 per cent in 2016, slowing to only a little over one per cent by 2020, and hence well below the OBR’s expectation for GDP growth at close to 2.4 per cent per annum.
  • The Government deficit is projected to stabilise at two per cent of GDP and hence the Government is projected to miss its target of balancing its budget by 2019/20.
  • Employment growth is expected to slow in 2017 before beginning to fall in 2018, accompanied by rising unemployment, up to 6.8 per cent of the labour force by 2020.
  • Net trade is expected to remain a drag on UK growth throughout the parliament with a balance of payments deficit remaining in the range four to five per cent of GDP until 2020. Consumer debt is projected to begin increasing rapidly, rising to 170 per cent of income by 2020, the highest ever recorded.

It is not widely appreciated that the OBR rely on an assumption that productive capacity in the UK economy will grow at a steady rate of close to 2.4 per cent per annum, and since the economy is already close to full capacity operation, 2.4 per cent per annum becomes their forecast for GDP growth. We regard the OBR’s approach as optimistic. As with all forecast models anchored around a trend rate of growth their insight into future growth is limited by their assumptions. This is an important limitation since the OBR’s approach underpins the Chancellor’s Autumn Statement and his plan to increase public spending while maintaining a target to reduce the public sector deficit to zero by 2019-2020.

The new CBR forecasts avoid any assumption about productivity growth and envisage that the remaining degree of planned austerity will reduce growth in GDP to 2.2 per cent in 2016 and two per cent in 2017 with growth below 1.5 per cent per annum in 2018-2020 and beyond. This in turn is projected to generate lower tax revenues than projected by the OBR, causing the Chancellor to miss his deficit target by some margin. Our forecast is that the Government’s debt will remain high, at 77 per cent of GDP in 2020 well above the OBR’s forecast of 71 per cent.

Faltering growth in GDP and rising interest rates are projected to lead to an end to the employment boom, and to rising unemployment after 2016. Austerity policies, even in the new austerity-lite form, mean that without strong stimulus from the UK private or foreign sectors the economy would lapse back into recession. In practice we believe that expanding household borrowing for housing and consumption will maintain growth in GDP up to 2020, albeit at a slowing rate.

However, a reliance on household borrowing to generate growth makes for an unbalanced economy. Household debt is already higher than government debt, and both household debt and house prices are projected to rise to unprecedented levels relative to incomes at the same time as public debt is planned to decline as a proportion of GDP. Eventually, the levels of household borrowing are expected to moderate as interest rates rise, and as indebtedness becomes unsustainable and house prices become unaffordable. The consequence is that beyond 2020 the main private sector driver of growth is expected to wilt, keeping subsequent growth in GDP below a slow rate 1.5 per cent per annum even if government spending picks up.

While the growth in household debt begins to moderate, the level of household debt is still projected to rise, leading to excessively high house prices, and this will make the economy susceptible to another financial collapse between 2020 and 2025.

The forecast report includes an alternative ‘reflation’ scenario in which government current and capital spending on goods and services grow much more rapidly than under existing government plans, including a substantial house-building programme by housing associations. The scenario selects the largest increases in spending compatible with inflation at under four per cent per annum and a ceiling on the ratio of public sector debt to GDP close to 80 per cent.

This generates a cumulative £160 billion of additional real public spending by 2020 and 400 billion by 2025. In this scenario real GDP grows 0.5 per cent per annum faster than in the baseline projection up to 2020 and unemployment remains low, at between four per cent and five per cent, and 700,000 lower than in the baseline forecast by 2020. The result is more balanced in that house prices are little higher by 2020 relative to incomes than today, and the ratio of household debt to income is lower than in the baseline projection. The reflation scenario would reduce the danger of a new banking collapse but at the cost of one per cent per annum higher inflation and higher public debt than in the baseline. While austerity runs a real risk of another financial collapse and recession, a reflationary approach carries the risk of higher public sector debt if a major economic shock were to spread to the UK from abroad.

Neither the baseline forecasts nor the scenario do much to regain lost output since 2008. In both cases GDP per head in 2020 is close to 25 per cent below the pre-2008 trend, with the gap continuing to rise thereafter. This demonstrates the limits of action in a single economy within a globalised world with a substantial international deficiency of demand. Reflation in the UK alone could substantially reduce unemployment for a decade or more but would leave price inflation at just under four per cent per annum and public sector debt in 2020 at close to 80 per cent of GDP. Per capita GDP would also be higher but only by a small amount.


In this CBR podcast Dr Graham Gudgin and Ken Coutts say more about their new economic modelling and how it differs from that of the OBR.

Dr Gudgin said: “Working through the Keynesian multiplier, somebody has to spend some money, and if the government doesn’t, we are in trouble. We are rescued from trouble to some extent, by the fact the private sector, particularly the household sector is spending, but it has to borrow to do so. And that is the central message in our report. The debt of the household sector is starting at a high level and if this goes on, we will reach extraordinary high levels.”

Ken Coutts said: “The Chancellor is focusing on getting public sector debt down, but he is not taking sufficient account of what is happening to private debt and our argument is this results in a very unbalanced economy. The Chancellor’s attempt to get the deficit down is being counterbalanced by private debt increasing, and the risk we will eventually run into credit boom, high house prices and another financial crisis. We can’t predict either when this will happen in terms of the timing or the scale, but what our modelling allows us to do is to highlight where difficulties are arising and to identify processes which we can see will be unsustainable. If the processes continue we can see there is likely to be another crisis in five or seven years’ time.”

Dr Gudgin goes on to explain further how the model works: “The OBR are predicting GDP growing at 2.5 per cent per annum; we say 2.5 per cent this year, going down to 1.5 per cent then again to one per cent. It sounds a small difference, but that difference is enough to do two things. Firstly it is enough to stop employment growing. We know that the economy hasn’t been doing that well at all but the fact that so many jobs have been created and unemployment has been falling means that most people are getting a look-in. If there is pain around it has been fairly widely shared, it is not like the 1930s. If GDP grows as slowly as we think, then unemployment will begin to rise in 2017, and we will get back to the peak it reached in 2008 and 2009, so that is pretty bad and pretty bad for the government.”

Dr Gudgin also warns of extreme indebtedness of households in the longer term: “Households have to spend their money if the economy is going to grow, but debt levels are now so high we will quite quickly get into extremes of indebtedness and an unstable economy as a result.”

But he says that the UK economy is also more generally reliant on the growth of the global economy too such as China and the EU. “All sorts of things can happen in the world economy. We are mostly optimistic, we are relying on a reasonable future for the world economy, but there is not much the UK government can do about these things; if the EU economy is growing very slowly we are in a bind.”

Ken Coutts believes their new model is a good one to base forecasting on: “All forecasting is to some extent a black art; it is a compromise between various judgements and the use of evidence. We use empirical evidence for the kinds of relationships we construct. The OBR forecasts have a high degree of judgement, it is refining its judgements as it goes along, such as when the elimination of the output gap will actually take place, and then the government spending plans are based on this. It is very hard to get turning points right in business cycles. What we can say from our model is that it is showing certain tendencies which if they continue will be unsustainable. It is answering those “what if” questions. Ours is a new model built over the past three years, based on the output of the real economy, things such as output, GDP, employment and unemployment, and the monetary side of the economy, the relationship between interest rates and the growth of debt. We think many conventional macro-models don’t get a proper linkage between these two and our approach is to bring these two together.”

Download the UK Economy Forecast Report (pdf, 2.1MB)

Access more special reports from the Centre for Business Research >

Read Larry Elliott’s article in The Guardian about the CBR report >

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