An office to calibrate degrees of uncertainty

Rarely has HM Treasury, the proudest and most powerful department of state, indulged in such painful self flagellation as in the "Note for Editors" published alongside yesterday's announcement of the new Office for Budget Responsibility.

In it, and reproduced here, the Treasury's economists have evidently been forced to delve, in excruciating detail, into their own failings. Like the Roman Catholic Church and the Iranian ayatollahs, the Treasury does not like to admit its fallibilities, but there is no mistaking the masochistic message from the bar charts: the Treasury is not to be trusted when forecasting its own borrowing.

What the official document terms the "serial correlation of forecast errors that has been characteristic of them over the longer term" is damning indeed, though it is also fair to point out that, in the early years of New Labour and in various episodes before, the Treasury could also get things wrong in a "nice" way, with borrowing coming out below forecast. It is also fair to point out that the very worst of the forecasting errors came in periods of huge international economic upheavals – the latest recession, of course, but also the oil shock of 1973, for example.

Put precisely, the Treasury says that over the past decade, the average one-year-ahead forecast (of the deficit as a percentage of GDP) was 0.4 per cent of GDP lower than outturn between Budget 2000 and Budget 2009, with average five-year-ahead forecasts 3.5 per cent of GDP lower than outturn, equal to £52bn in today's prices.

The Office for Budget Responsibility (OBR) has few real international parallels. Sweden and Canada have something similar; the US Congressional Budget Committee also has an audit role. It is certainly a new departure for the UK. The OBR is destined to take even more of the politics out of British economic policymaking, a process that has been slowly proceeding, on and off, for about 30 years.

The OBR will indeed take over from the Treasury responsibility for making economic forecasts, and remove the tendency to optimism that has sometimes characterised them. It would be a surprise, for example, if the OBR's forecasts differed markedly from other authoritative external assessments routinely made by the Bank of England, the National Institute of Economic and Social Research, the European Commission, the IMF and so on.

These all put the UK on track for growth of 2 per cent or so next year, against 3.25 per cent according to Alistair Darling's last Budget. The new rules mean that the Treasury – which actually had a fairly respectable record on forecasting GDP growth, if not the public finances – will no longer even be tempted to be an "outlier" in economic forecasting.

As recent experience also underlines, that does not mean that the OBR will get things right. Economists, especially in the City, tend to have a "herd instinct" when it comes to forecasting, not least because they often all use the same assumptions and models, some even mimicking the Treasury's own forecasting techniques. Bad luck, an economic shock at home or abroad, the unexpected behaviour of consumers or companies, or a "new" kind of problem such as the credit crunch all mean that the OBR may not actually have a materially better track record in economic forecasting than the Treasury. Sir Alan Budd and his team have not been granted a statutory monopoly on wisdom by George Osborne.

As for the predictions themselves, it seems they will be in the form of a "central forecast", with a range of possibilities around them. The Treasury uses a range of 0.5 percentage points – a lot in such matters. It seems less likely that the OBR will follow the Bank of England in producing a "fan" forecast, showing a bewilderingly wide range of possible outcomes the further into the future one ventures. The Bank's forecasting approach, published four times a year in the definitive Inflation Report, is mature and realistic, given the usual risks to the downside and upside, but even professional Bank-watchers sometimes find it tricky to discern precisely what the fan chart is saying, if anything.

The independent assessment of the Treasury's judgements on public borrowing is also new, and also subject to the same complaint.

The OBR will look at the Government's fiscal targets – eliminating the structural deficit by 2015, say – and judge whether the Chancellor's plans seem more than 50 per cent likely to meet them. That still leaves, theoretically, an almost even chance that he will not, but the OBR will still give the plans the thumbs-up.

The reality will be that the OBR will be working very closely with the Treasury – a full and free exchange of data and analysis is the only way this arrangement can be made to work – even though the OBR will be an external agency of the Treasury when it is finally set up, and move out of the Treasury's buildings. The OBR's economic forecast is intended to be out before the Chancellor's Budgets, and the Chancellor will couch his own statements in light of them; his numbers ought then to be approved by the OBR. It will all be very close.

So how far the OBR will go in questioning Treasury data is open to question. Will the OBR, for example, be able to point out the sort of "black hole" in the last government's spending plans that the Institute for Fiscal Studies (IFS) did? The IFS remains a completely freestanding and independent body. We will still need it's robust and outspoken contributions.

The third task, of detailing the British state's long-term commitments to public sector pensions and PFI schemes, is entirely new. Thus far only occasional estimates of the value of these multi-trillion pound liabilities has been produced by government, supplemented by estimates from the IFS, the CBI and others.

The reason they matter is that the nation's ageing population inevitably means higher public spending on health and pensions, leaving all else unchanged. This "age adjusted" view of the public finances will add something novel to the debate about reducing the deficit.

The Office for Budget Responsibility is, in truth, the latest event in a three-decade-long slow revolution in the way the country runs its economic policy – with power ebbing from politicians towards technocrats.

On the fiscal side, cash limits after the 1976 IMF crisis began the process of bringing discipline to affairs; the Medium Term Financial Strategy framed by Nigel Lawson in 1980 attempted to set a longer term, more certain, framework for economic policy, as did Gordon Brown's Fiscal Rules after 1997. Operational independence for the Bank of England that same year was the great leap that took interest rate policy out of the hands of politicians.

Underlying all these moves was the anti-Keynesian assumption, explicitly endorsed by Mr Osborne, that fiscal policy is there to promote "supply side" efficiency and enterprise and not to manage the overall economy, a task best left to monetary policy, now in the Bank of England's hands. Recent experience suggests there is more room for fiscal stimulus at a time of distress and when monetary policy becomes ineffective (as Keynes pointed out).

Whatever the intellectual underpinning, the OBR is the same in one respect as any other creation of government; it can be abolished. What a Chancellor giveth he can take way. Had the OBR existed during the last financial crisis there seems little doubt its judgements would have been sidelined in the same way that the UK's Fiscal Rules or the Maastricht Treaty rules were jettisoned. Will the OBR survive its first crisis?

The man leading the OBR

*Sir Alan Budd is one of Britain's most distinguished economists. He was an economic adviser to the Heath government before going into academia and holding a high profile post as professor of economics at London Business School. In the Major government he served as chief economic adviser to chancellors Norman Lamont and Kenneth Clarke, a position he held until New Labour came to power in 1997. He served on the Bank of England's Monetary Policy Committee between 1997 and 1999. Since then he has been provost of Queen's College, Oxford.

*In a recent essay for the National Institute of Economic and Social Research's Review, Sir Alan said that Labour's policies "appear to have resulted in ignominious failure", left the UK "less well placed than it might have been to meet the challenges" and condemned the "triumphalism and exaggerated claims to novelty" by Mr Brown.

Sir Alan also said that there should be a persistent effort to reduce public debt as a share of GDP to create more room for manoeuvre for the next crisis, a tougher path for retrenchment than anyone has yet suggested. Sir Alan also criticised the "over-optimism of forecasts from 2001-02 onwards".

*Sir Alan has admitted that "it is well recognised that fiscal forecasts are subject to considerable uncertainty, which may be irreducible".

*In 2004 he was asked to report on the circumstances surrounding the issue of a visa to the nanny of Kimberly Quinn, the lover of the then Home Secretary, David Blunkett. Mr Blunkett resigned.