Waving, not drowning: why the OBR’s gloom is wrong

With apologies to Stevie Smith’s rather dark poem, I thought this was an appropriate one-liner to describe the UK economy right now, against a backdrop of consensual gloom, a vindictive Budget and seemingly unending global conflicts.

This brief period between the Budget and this week’s interest rate decision, which will be announced on Thursday, provides a good opportunity to lay out the arguments for and against the “drowning” narrative, and to explain why, against the odds, I remain considerably more upbeat than any of the post-Budget commentary I have read so far. Much of it, by the way, appears to treat the OBR’s forecasts, which accompanied the Budget statement last Wednesday, as scientific fact rather than the product of what I believe is deeply flawed, muddled analysis that is not fit for purpose. This will be a familiar refrain for regular readers but, as a relatively lone voice on these issues, I thought that they deserved another airing.

The case for the drowning economy is well rehearsed by the media and consensus economics, and it’s easy to see why it’s so popular. Out-of-control government spending has led to high and rising taxation and excessive borrowing and, if the OBR is to be believed, poor productivity growth in the future will lead to continued subnormal growth outcomes over the next five years. These problems, along with the conflicts in the Middle East and in Ukraine and the high energy prices they have caused, complete the depressing narrative. The final element of the drowning economy storyline is the much-anticipated monetary policy response that the “market” and the OBR now anticipate, with base rates expected to increase to 4.75% in 2028, 100bps above where they are now.

Like all good myths, there are some facts sprinkled into this storyline which I agree with, but there is equally a lot of guesswork too. This note will briefly cover those facts and then seek to dismantle the drowning narrative with evidence and some forward-looking alternative analysis of my own.

A public finance mess

First, to what Andy Haldane described over the weekend as “a public finance mess”. Although I slightly disagree with some of Andy’s conclusions, I do agree that this government has, in practical terms, lost control over public spending. Of course, it would vigorously dispute that characterisation, but the numbers speak for themselves and are scary. Total managed expenditure, having increased by £75bn in fiscal 2025-26, is now forecast to increase by £84bn in 2026-27. That’s a 6% increase this year alone, and £31bn more than the OBR had forecast back in March this year.

That means that total government spending will be 6.5% of GDP larger this year than in 2019. Of that 6.5% increase, roughly 1.2% is increased gross investment on really useful things like HS2, leaving 5.2% of GDP on current spending. Of that 5.2%, 1.0% is on welfare, 2.2% is on debt interest, and 2.0% is on everything else spent by government departments.

As you can see from the OBR’s figures above, future government spending is forecast to peak close to 46% of GDP in 2028 and then to decline slightly, but that is predicated on the government being able to slow expenditure growth over this period from 6% to 3% a year. For a government that has to date been utterly incapable of doing that, you have to wonder whether this is achievable, despite the pressures exerted by the limits of taxation and borrowing that the government is bumping into. However, given its very public commitments to its fiscal targets and its manifesto promises (albeit they have hitherto been flexibly interpreted), and the close attention that will be paid by financial markets to the government’s 2027 Spending Review, there may at last be enough pressure on Healey and Burnham to do the right thing and, very belatedly, exert some authority over public spending.

That aside, what is clear is that the pandemic left a strange and troubling legacy in the economy that appears not only to have changed what society expects from the state, but also to have created an addiction to higher public spending within the institutions of the state as well as amongst politicians. This pattern is not unique to the UK and is seen across many peer economies, but not, interestingly, in Sweden, which adopted a very different approach to the pandemic and where, as a percentage of GDP, government spending is now lower than it was before the pandemic.

There are a couple of points to make on this critical aspect of the economy. Whilst I think it’s obvious that government spending is out of control, and both too high and growing too fast, I disagree pretty fundamentally with the OBR’s growth projections for the overall economy over the forecast period, and so I don’t subscribe to the inexorable rise in the spending-to-GDP ratio shown in these charts. Indeed, if I am right about growth in the economy surprising to the upside over this five-year period, government spending could still grow at somewhere close to the 3% level (still too high in my opinion) but actually fall as a percentage of the economy, given that nominal GDP could, on my forecasts, exceed 4% a year over the period (2% real growth plus 2% inflation).

I will explain in a bit more detail why I believe in this better growth outcome later in this note but, if I am right, the current budget, which excludes public sector net investment, would move into surplus as early as fiscal 2028-29, in part because frozen tax allowances continue to drive higher revenues.

In other words, although this government and its predecessors have spent and taxed recklessly, the economy’s better growth outcomes drive a faster improvement in the public finances than the OBR has forecast. What happens then will be very interesting given the options available. The government could bank the improvement in the public finances and stand back and watch debt to GDP fall, or it could cut taxes or increase spending again. Given that the general election has to happen before August 2029, it doesn’t take a genius to work out which might be most popular with those who will be voting.

The energy squeeze is near its peak

The next bit of the drowning narrative is shared with most other economies, and that’s the energy price squeeze. Some institutions, like the IMF, seem to believe that the UK is especially vulnerable to high oil and gas prices and said so at the start of the latest crisis. But once again the reality has been somewhat different. The UK economy has coped better than its peers with the energy price shock. Growth has been much better and inflation lower, both at an underlying and headline level, and a hell of a lot better than either the Bank of England’s or the OBR’s forecasts. Despite this better-than-expected outcome, I have seen very little acknowledgement of the factors that led to this “surprise”. In fact, those that got it most wrong, like some members of the MPC, far from acknowledging their error, have kept banging on about second-round effects and may well decide to increase interest rates later this week in a quixotic tilt at mythical inflationary potential. In my opinion this would be a mistake. Far more appropriate would be a cut in interest rates, but that is about as likely as me flying to the moon with a piano strapped to my back.

The critical issue here is that if rates do increase, in my judgement it will make very little difference to growth and will have absolutely no impact on the things that have driven inflation to about the 4% level, which is where it will peak early in the new year when the energy price cap goes up in January. Mortgage rates have also already adjusted to the recent increase in market interest rates, and so a quarter-point move, if it comes, will have minimal impact here too.

More important, in my view, is what’s likely to happen to energy prices. Aside from the slightly more positive noises emanating from the protagonists in the conflict on Monday, which have been interpreted as a sign that a settlement of the war is a bit more likely, the fact is that the volume of crude leaving the Gulf area is so significant, and now exceeds pre-war volumes, that it is hard to see the price escalating much above current levels ($104) and sustaining that higher level for long. It’s also the case that, come the end of February and the first anniversary of the conflict, the economy will be annualising much higher energy prices, and so the impact on headline inflation will be much reduced. So my guess is that we are close to the peak of inflation and, if a settlement is reached in the days ahead, its future path is much lower, quickly.

Once again, if I’m right, then even if rates do rise this week, that will be the last increase in this cycle. If a peace deal is signed, then the next move in rates will be down, and that will be followed by further cuts through next year.

In contrast, the drowning narrative, or consensus by another name, has UK interest rates increasing to 4.75% by about the start of 2028, despite the fact that inflation is by then back at the 2% target. It’s this gloomy outlook for rates, driven by market-derived pricing, which is embedded in the OBR’s conditioning assumptions. These in turn drive its higher debt interest cost and public spending forecasts, and its lower growth expectations, which everyone seems to have accepted as fact despite them being totally inconsistent with the OBR’s own inflation forecast.

So, in summary, in my world the energy price squeeze is near the peak of its negative impact on the UK economy and, if interest rates go up on Thursday, that will be it. If a settlement in the Gulf is reached, then energy prices fall quickly, although they will take a while to get back to $70, and gas prices will fall too. Interest rates will then follow inflation down to the level they would already be at had the war not started back in February.

The productivity mistake

The final flaw embedded in the downbeat, we’re-drowning consensus narrative is the OBR’s forecast for productivity growth. I’ve written about this important issue on several occasions in the past and highlighted why I think the OBR’s analysis and its estimates for productivity growth are mistaken, but there is no sign yet of a volte-face from this pillar of the economic establishment. Productivity is a concept which cannot be precisely measured, because it relies on the assessment of both outputs and inputs, which are really hard to measure. My judgement is that in recent years the ONS has had problems with both the numerator and the denominator in this calculation.

More specifically, output in the UK, which is the numerator in this ratio, is hard to measure and relies on all sorts of guesses, surveys and estimates which, in some important sectors of the economy, can only be assessed remotely via proxy measurements and quality adjustments. Imagine, for example, measuring the output of a fire station that had never put a fire out, or that of a school or college with remote learning, or of a hospital or a law firm or a bank or a research institute, or even of a regiment in the army. But then imagine how proxies of output from these organisations might change as they all embraced different working practices and new technologies that, in the health sector for example, might reduce disease incidence.

On top of these challenges, there are also problems measuring inputs, and it is here that the ONS has had the most high-profile problems in recent years. Inputs in this case are the number of hours worked in the economy, the denominator in the productivity ratio. But this can only be assessed if the number of people in work can be accurately measured. Unfortunately, the survey that the ONS has relied upon to make this assessment, the Labour Force Survey or LFS, is significantly flawed because it has been overestimating the number of people in work and, consequently, the number of hours worked. As a result, its estimate of output per hour, or productivity, has been underestimated. I first wrote about this problem two years ago and, because the discrepancy between the LFS and more reliable measures of employment has been increasing (see the chart below), the resulting productivity calculation has become increasingly unreliable.

Despite these serious problems, the OBR continues to base its forecasts for productivity growth on this flawed measure and, as a result, in my opinion it is significantly underestimating the future growth potential of the economy. Indeed, in 2025’s Budget the OBR downgraded its long-term productivity growth forecast from 1.3% to 1.0%, just as more compelling evidence was emerging that confirmed this measurement error. Since that downgrade, a number of respected economic research houses, including the LSE and the Resolution Foundation, have also cast doubt on LFS-based assessments of productivity performance and have calculated that the gap between their assessment and that used by the OBR is as much as 1% (see below).

In last week’s updated forecasts for the UK economy, the OBR has gone even further and downgraded its overall growth forecast for calendar 2027 to 1% (from 1.5% in March), largely as a result of yet another productivity growth downgrade, to 0.7%.

In my judgement the OBR has got this very wrong, just as it has before. The growth surprise this year, which has clean bowled the economic establishment, is in part the result of this productivity miscalculation. Since the government significantly increased the cost of employing people, which started in its 2024 Budget, companies have been shedding labour and, not surprisingly, this has coincided with much higher levels of business investment. Back in March the OBR forecast that business investment would fall by 0.9% this year. In fact, the outturn will be something close to growth of 5%.

But this isn’t the only factor boosting business investment. The AI industrial revolution is also rippling through the UK’s service-focused economy and creating opportunities for businesses to increase productivity across many sectors by investing in automation.

These two profoundly important factors have already had a massive impact on the economy and will continue to do so. My view is that they will drive much better productivity growth over the next five years than the OBR is forecasting, and in turn much better growth outcomes too.

Watch · S2 Ep 16Last week’s Show: Britain can grow its way out of this Budget

A wave to the establishment

The UK economy drowning narrative has become the staple diet of most media commentators and economic research houses, and appears to be the central mantra of the OBR and the Bank of England. It has become depressingly familiar, and yet is itself fundamentally flawed. It relies on assumptions which do not stand up to thorough analysis, and on others which reflect a glass-half-empty perspective on continued global conflicts, elevated energy prices and daft market-derived interest rate forecasts.

Despite the considerable headwinds endured by the UK economy this year, it has continued to exceed expectations, displaying much greater resilience than was expected by the consensus. Not only has growth been better, but inflation has remained subdued despite the war and its effects on oil and gas prices. Next year I expect growth to once again exceed expectations and, instead of the 1% forecast by the OBR, I expect something approaching double that. If the war in the Gulf comes to an end, the outcome could be even better.

Better productivity outcomes and higher business investment will be central to this underlying performance, as will further falls in household saving which, although remaining well above long-term averages, will continue to ease back from the very elevated levels of recent years. When I think of the UK economy’s immediate future, I see one characterised by better growth and lower inflation and interest rate outcomes and, with that upside surprise, a metaphorical wave to the economic establishment’s overwhelmingly negative perspective.