Stephen King: The Office for Budget Responsibility must be prepared to defy the fiscal consensus

The Treasury will no longer have the opportunity to redefine the economic cycle or fiddle the economic forecasts to suit its own purposes

It hasn't enjoyed quite the fanfare that came with Gordon Brown's decision to make the Bank of England independent back in 1997, but the establishment of an Office for Budget Responsibility (OBR) in the early days of the coalition is George Osborne's opening contribution to the longer-term stabilisation of the UK economy. Rightly, the new Chancellor of the Exchequer recognises that the UK's public finances are in a complete mess. He hopes to avoid future chaos by subjecting his own budgetary numbers, and those of his successors, to independent scrutiny.

This, I think, is a good idea, even if Mr Osborne's job has suddenly been made harder in the short term by the resignation of his Chief Secretary, David Laws. The smoke and mirrors routinely employed by Mr Brown when he was Chancellor created the appearance of fiscal stability when, in reality, the underlying position was deteriorating all the time.

In the early years of New Labour's administration, Mr Brown put in place fiscal rules which, on the face of it, seemed to do precisely the job now being asked of the new Office. His "golden rule" demanded there should be no borrowing for current expenditure through the course of an economic cycle. His "sustainable investment rule", meanwhile, required the government not to live beyond its means via a commitment to keeping government debt low and stable as a share of national income.

Given these self-imposed constraints, how have we ended up with a catastrophic deterioration in the public finances? The most obvious reason is simply that Mr Brown persistently redefined the UK's position in the economic cycle to suit his short-term needs. Intent on boosting spending on "essential" public services, he assumed the good times and revenues would roll, a view summed up in the ludicrous claim that there would be "no more boom and bust". He failed to learn the lessons of one of the earliest economic cycles. If Joseph and Pharaoh knew they had to put grain aside during years of plenty, it surely wouldn't have been so difficult for Mr Brown to have acted in a similar manner. Maybe he skipped his Bible studies classes.

Another reason was the lack of market discipline at a time when markets supposedly knew best. Before the financial crisis, investors all over the world were blindly prepared to trust governments' fiscal promises. They, too, had failed to learn the obvious Biblical lessons. Entranced by low inflation and egged on by the massive and cheap inflows of capital from China and other high-savings nations, they snapped up all manner of bonds with no questions asked. That made it easy for governments to live beyond their means. Few imagined that easy credit in the private sector would ultimately lead to excessive debts within the public sector.

If, then, the Office for Budget Responsibility is to do its job well, it will not only be required to provide the economic forecasts needed to underpin the Government's fiscal plans and make judgements on the likelihood of those plans being realised, but also assess whether the financial markets are being too forgiving. These are hardly easy tasks. Sir Alan Budd, the eminent economist who has been appointed to run the new Office, will have his work cut out.

Let's think for a moment about the scrutiny of the fiscal numbers. The independent Institute for Fiscal Studies (IFS) does this all the time and is no slouch when it comes to criticising fiscal plans. It's instructive, then, to recall what the IFS was saying back in 2007, just before sub-prime entered the lexicon of modern discourse. Following the 2007 Budget – Gordon Brown's last as Chancellor – the IFS concluded that while there had been a "slight deterioration in the public finances ... both fiscal rules [were] on course to be met". This hardly counts as a piercing intellectual rejection of the Government's fiscal plans. The reason is obvious. The IFS, like most other commentators, simply failed to see the financial car crash around the corner.

To my knowledge, despite Joseph's wise economic counsel, there is no suggestion in Genesis that merely achieving low and stable inflation could solve Egypt's economic problems. Yet many economists, alongside Mr Brown, thought the delivery of low inflation would be sufficient, on its own, to avoid booms and busts. Even economic atheists should have known better. Given the behaviour of the US economy in the roaring 20s and Japan in the bubbly 80s, it should have been obvious that low inflation and economic stability don't always make good bedfellows.

So how might an Office for Budget Responsibility have fared at the time of the 2007 Budget? Back then, the vast majority of forecasters, including the Treasury and the Bank of England, shared a belief that the two-year-ahead outlook for the economy was reasonably sunny (Geoffrey Dicks, now one of the members of the OBR but, in 2007, an economist with RBS Financial Markets, was particularly upbeat about the UK's economic prospects, his numbers being within a whisker of those published by Mr Brown). Meanwhile, investors were happy to buy gilts at very low yields. It would have taken a remarkably brave man to have declared that the Government was living way beyond its means. And it would have taken a remarkably trustworthy government to have believed him.

Think of the implications. The head of the OBR would, in effect, be advising a government to rein in its spending plans or raise tax rates in the absence of any kind of consensus that the economy was about to plunge into recession and, thus, that the Government was living beyond its means. Even worse, if the economy were subsequently to head into recession, the head of the OBR, having demanded fiscal austerity, would probably be hounded out, a convenient scapegoat for a government hoping to shore up political support in the light of economic failure.

The formation of the OBR cannot possibly be a panacea for the UK's underlying economic difficulties. It's important for investors, the public at large and, indeed, the new Government to understand the Office's limitations. Nevertheless, even allowing for the constraints imposed by economic "group think", the OBR should be able to deliver modest improvements in economic policy-making in the years ahead (which, with any institutional innovation, is about the best we should be hoping for).

The Treasury will no longer have the opportunity to redefine the economic cycle or fiddle the economic forecasts to suit its own purposes. With the Government subject to independent fiscal inspection, the risk of a sovereign downgrade should be reduced, thereby protecting the interests of UK taxpayers. And, if the OBR really has teeth, any fiscal misdemeanours should lead to welcome parliamentary scrutiny at a relatively early stage.

The really big challenge for the OBR, however, is finding a way to escape from group think. Good policy-making depends not on adherence to a central forecast but, instead, on the risks around that central projection. Even the Bank of England, which routinely publishes fan charts designed to capture both upside and downside economic risks, failed to capture the catastrophic meltdown associated with the credit crunch. The OBR will need to think the unthinkable and explain to sceptical politicians why they need to pay attention to events which, while seemingly unlikely, present an existential challenge to our economic well-being. The politicians, in turn, will have to weigh up the trade-off between manifesto commitments and unlikely, but hugely disruptive, economic outcomes. I wish Messrs Osborne and Budd all the luck in the world. They will certainly need it.

Stephen King is managing director of economics at HSBC