Stephen King: The murky mysteries of the economic cycle

It wouldn't be a bad idea to open up the assumptions made by the Chancellor to greater scrutiny

Economics is the science of the vaguely knowable rather than the precisely predictable. Many economic theories, particularly big picture theories at the macro-economic level, make an awful lot of sense in theory - as, indeed, they should - but they're not always quite so helpful in practice. And, even when they do make sense individually, they don't always hang together terribly well collectively.

Take business cycles. All of us think we know something about the evolution of business cycles. The language of business itself is full of it: upswings and downswings, booms and busts, recessions or, even worse, depressions. Yet, when it comes to understanding why cycles happen at all, and where we are in the current economic cycle, it all begins to get a little murky.

Part of the problem lies in understanding why cycles occur in the first place. Some people think there is a natural cyclical path established by movements in inventories. Final demand appears to be stronger than it really is when companies are rebuilding their inventories, leading people to overestimate future growth. When growth turns out to be not so strong, inventories are reduced, leading to final demand appearing to be weaker than it actually is.

Others focus more on exogenous shocks. Would the mid-1970s economic crisis have been possible without the quadrupling of oil prices in 1973? Would the 1930s depression have been quite so bad had the US not imposed the Smoot-Hawley tariff in 1930? The exogenous approach argues that cycles wouldn't be there at all in the absence of these essentially unpredictable events.

Then there are those who focus on the "political" element of economic cycles. Policymakers, particularly politicians, create cycles because their preferences don't equal the preferences of society. A politician focused on the electoral cycle may make economic policy decisions that suit re-election more than the good governance of the economy over the medium term. Mercifully, the increasing independence of central banks has gone some way to reducing this particular problem but, on the fiscal side, the incentive is still very much there.

Above all of this, though, are the unfathomable "animal spirits" of businesses and households. As Keynes put it: "Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities".

Of course, this doesn't mean to say that animal spirits are entirely unpredictable. My cat, for example, has regular eating habits and regular toilet habits (although his visits to the litter tray are disturbingly hit and miss). Nevertheless, it's fairly clear that Keynes regarded the business cycle as in one sense a mysterious thing, rather difficult to predict because markets weren't always capable of settling down to a nice equilibrium. In Keynes's world, disequilibria were both possible and persistent, even if unpredictable.

All of which creates problems for Gordon Brown. Last week, the Treasury announced that the Chancellor would be delivering his Pre-Budget Report on 2 December. In that report, he will have to come up with his latest views about the economy and its relationship with the public finances. As part of this process, he will have to tell us about the size of the output gap.

The output gap is, conceptually, a simple idea. It's a measure of the degree to which the actual economy has strayed away from its long-term "sustainable" path. If output is above this sustainable path, there will be a tendency for inflation to rise. If output is below this path, there will be a tendency for inflation to fall (or, in a world of sticky prices, unemployment to rise). In other words, the output gap is no more than a measure of where we are in the economic cycle.

The output gap is an important concept in the field of public finance. A booming economy will be associated with bumper tax revenues and unusually low public spending on things like unemployment, and hence will give the impression of an unusually healthy set of public finances. It's only when the economy comes back down to earth - to a sustainable path - that the true nature of the fiscal position is revealed. Equally, a recession-hit economy will be associated with tax shortfalls and higher unemployment benefits, suggesting an unusually unhealthy set of public finances.

In making a judgement, therefore, about the medium-term sustainability of the public finances, it's important to correct for the effects of the economic cycle - something that was never fully spelt out in Europe's Growth and Stability Pact, with the result that those countries subject to its strictures have increasingly ignored them.

And this is what the Treasury tries to do. The left-hand chart shows the Treasury's latest published estimate of the output gap. The chart suggests that the latest economic cycle will come to an end (i.e. the output gap will close) by the first half of 2006. By that stage, the economy will be back to some notion of "normality". If the Chancellor sticks to this forecast, he will also need to show that, by 2006, he meets his so-called "golden rule" - which says that "over the economic cycle, the Government will borrow only to invest and not to fund current spending".

Let's say, though, that Mr Brown is unable to meet the golden rule over this period. Maybe the fiscal numbers simply don't add up. What then? The Chancellor has two choices. Either he can say that he's failed his fiscal rules and apologise profusely. Or he can simply change his estimate of where the output gap lies.

For a politician, the second of these two options is more appealing. The right-hand chart shows two different OECD estimates - one made in 1996, the other made this year - of where the UK output gap was between the mid-1980s and the mid-1990s. Although the overall pattern of the two estimates is not so different, there are considerable differences in many of the individual years. And, because of this, the output gap is a concept easy to exploit: its very imprecision opens it up to abuse.

Perhaps, then, it wouldn't be such a bad idea to open up the assumptions made by the Chancellor to greater independent scrutiny. It's not that the output gap estimates made by the Treasury are necessarily wrong; none of us knows exactly where the gap is at any point in time. Rather, greater scrutiny would enable the Chancellor's fiscal calculations to be assessed in a more objective fashion, removing the burden from the Treasury of being both judge and jury on the fiscal position. As the House of Lords Economic Affairs Committee remarked in its report last week ("Monetary and Fiscal Policy: Present Successes and Future Problems"), "we respond more positively to the idea of having an independent assessment by experts of whether fiscal policy is being conducted within the fiscal framework. We think that either there should be a body like the Council of Economic Advisors in the US, or parliamentary scrutiny of these matters should be increased."

Of course, there's no guarantee that the experts would be any better than the Treasury in estimating the cyclical position of the economy. At least, though, their presence would help remove the temptation to fiddle the fiscal framework under pressure from the expediencies of the electoral cycle.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com