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Why the Office for Budget Responsibility matters

Stephanie Flanders | 08:42 UK time, Monday, 17 May 2010

It's democracy: but not as we know it. That's been many people's dazed response to the advent of coalition politics in the UK.

Nick Clegg and David CameronOne minute British politics was a battle of competing tribes - the next we had two terribly nice chaps in the garden of No 10, united by their desire to "do the right thing".

For some it will feel like the heart has been sucked out of government. For those of a more technocratic bent, it will be about time. Finally, they will say, we can strip away the fancy ideology and get down to what actually works.

I suspect that many people will feel both: relieved if it means less yah-boo politics, but also disconcerted about where it will lead.

Funnily enough, for anyone wondering what to make of the new politics, the creation today of the Office for Budget Responsibility (OBR) could be an interesting test.

It's no accident that the creation of the OBR will be one of the first acts of this new administration - like Gordon Brown's (then) shocking decision to make the Bank of England independent in the early days of the new Labour government in May 1997.

George OsborneAs a voluntary surrender of executive power, the OBR does not (quite) rank alongside that transfer of power to the Bank. As Mr Osborne has himself said, the analogy is inexact because you can't give an unelected body "independent executive power over the levers of fiscal policy."

The OBR will not set tax rates like the Bank of England sets the bank rate on which every other interest rate in the economy is based.

But make no mistake: like an independent Bank of England, this new institution has the potential to become a hugely powerful force. It will not set the rate of VAT - or spending on the NHS.

But when it comes to budget policy, this government is going to be on a much shorter leash than the one that came before.

Last week we discovered that the new chancellor had, in effect, asked the governor of the Bank of England's permission to go ahead with his plans to cut public spending this year.

Mr Osborne has said all along that he would seek Mervyn King's advice in setting his policy. Once he had got the thumbs up, on Tuesday, the chancellor was keen that the governor should tell us what he thought in his Inflation Report press conference the following day.

As I reported on the day, this was something new. Was it welcome? Again, those of a technocratic bent would say yes. It's been a long time since monetary and fiscal policy were so mutually interdependent. Now more than ever, each lever of macroeconomic policy needs to know exactly what the other is doing.

Then again, no-one ever voted to put Mervyn King in his current post. If last week had not been so full of historic firsts, you might have heard more people questioning whether he should have played such a key role in making this hugely important political call.

We are told that this was a one-off. The governor does not plan to give a running commentary of British fiscal policy. But that is exactly what the new OBR will do.

At least twice a year, this unelected three person body, with its own staff, will publish independent fiscal forecasts around the time of the Budget and pre-Budget report.

Like the Bank, it will be given the government's medium -term target (in this case, for the budget deficit - or surplus rather than inflation). On the basis of its independent forecast, it will then recommend how much policy needs to be tightened or loosened to have a decent chance of meeting that goal.

Yes, the chancellor can ignore this advice. But the point of the exercise is that politically this will be very difficult to do.

Many in the Treasury are nervous of the new regime. Supporters of the OBR will say they have no-one to blame but themselves - or at least their old masters.

The macroeconomic forecasts under Labour were not as bad as they were cracked up to be (in fact they were often better than City predictions). But the revenue and borrowing forecasts in the latter years of the Labour government were objectively atrocious.

The likes of the National Institute of Economic and Social Research and the Institute for Fiscal Studies said they were optimistic at the time - but no-one knew quite how far off the mark they would turn out to be.

True, the financial crisis was exceptional - causing a collapse in revenues from the City that few could have predicted. But tax revenues were being consistently overestimated by Gordon Brown's Treasury, long before Northern Rock.

In the old days, politicians weren't very good at setting interest rates either. This didn't matter so much when inflation was not very high. But in the 1970s and 1980s, it became very important indeed.

Around the world, central banks started to get the power to run monetary policy for themselves. This was not just because they were outside politics, but because the belief they were outside politics actually made it easier for them to do their job: popular expectations of inflation were more likely to stay low.

That is and was a real and tangible benefit to Bank of England independence that Mervyn King is understandably keen to retain.

Now the deficit is public enemy number one, and once again, the argument is that things will be better for everyone - including the elected government - if its freedom of manoeuvre is more tightly constrained.

That is why independent experts like the IFS have cautiously welcomed the idea of an OBR, though they think the details will need to be carefully worked out. But even the greatest fans of this new institution may still stop to ponder what has been lost - and what has been gained.

As with monetary policy, it is possible that the mere fact of being independent will make the OBR's job easier than it was in the past. The long-term cost of servicing the public debt could now be lower, because investors know there is a highly visible independent body overseeing the books.

But the world has not had an enormous amount of experience of these bodies. It is less clear than in the case of monetary policy what the government is getting for its loss of control.

Yes, the OBR will not be politically motivated - or not in the same way as the Treasury might have been in the past. But - as any glance at the record of other forecasters will show - that is no guarantee that they will be right.

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