Scottish Economy Watch

Autumn Statement: smoke and mirrors

Chancellor George Osborne will stand up in the House of Commons today to make an Autumn Statement on the government's finances and the prospects for the economy.

The statement will be full of references to growth. The Chancellor's likely failure to meet his deficit and debt targets will be attributed to the weak underlying growth of the UK economy after the financial crisis. More austerity will be needed to meet his targets.

There will be no mention in his statement that his own policy has played a considerable part in the current weakness of the British economy.

It is true that the Chancellor can point to the views of the OBR, IFS, and others who believe that the supply capacity of the UK economy has been damaged by the financial crisis and Great Recession. In technical terms their view is that productivity growth is so slow and the recovery so weak because the crisis has led to productive capacity being lost forever in particular sectors and activities. The 'output gap' between supply and demand is small. Hence, to get more growth more capacity is needed. And that requires investment by both public and private sectors.

There is no doubt that there is some truth in this story. Labour productivity is clearly weak. But there is little other evidence that the economy is supply constrained.

A supply constrained economy would see wages and other factor prices rising quickly generally and specifically in those sectors that are most supply constrained.

There is no evidence of this.

Although advocates of the supply-constrained view suggest that wages and prices would be falling if the output gap was large. But this surely flies in the face of all the evidence that wages and prices are sticky downwards in most modern economies.

Moreover, with interest rates close to zero, at the zero lower bound, the economy is in a liquidity trap with nominal rates unable to fall far enough to equate the demand and supply of money, and savings and investment. The result is a deficiency of aggregate demand unless and until demand increases directly. And what we do see is clear evidence of a lack of demand. Household spending is weak, investment is weak, net export demand is weak and the government is engaging in an unprecedented programme of fiscal consolidation.

So what can we conclude?

First, estimates of the output gap are just that: estimates, difficult to realise and subject to error. Secondly, suppose, as Simon Wren Lewis argues that supply is following demand. Raise demand and supply increases as discouraged workers re-enter the labour market, as firms raise production from their existing workforce by staff beginning again to operate at more normal levels of input, and as idle plant and machinery - from bankrupt and closed firms as well as currently operating firms - is brought on stream. Thirdly, if supply also follows demand and then after a time is lost forever - what economists call hysteresis effects - then the costs of not seeking to stimulate demand are high.

Against this background Wren Lewis argues that

policy should lean towards being optimistic about supply, even if we are somewhat sceptical that it is really following demand - because the costs of self-fulfilling output gap pessimism could be so high.

But we won't get that in the Autumn Statement today.

Any spending changes the Chancellor introduces are likely to be at best fiscally neutral and at worst fiscally tightening. That is he will either seek to keep to his budget deficit targets or may tighten them.

Spending more on capital investment projects, schools and hospitals, will, if it comes at the cost of reduced spending elsewhere in departmental budget, have little if any stimulative effect on aggregate demand. Indeed, if the deficit target tightens it may have a depressive effect on the economy.

One way that the changes might stimulate demand is if the fiscal multipliers associated with the spending rises are higher than those associated with the areas where spending is being cut. We don't have relevant UK data. But I have my doubts. Increased spending on so-called 'shovel-ready' capital projects will boost supply in the medium to longer term. But will it boost demand in the short term if it is funded by civil service redundancies in other government departments?

It may do since the fiscal multiplier on infrastructure and particularly capital spending on roads and highways is, from US research, quite high. But it won't be that much higher than the negative spending effect of civil service job cuts and other spending cutbacks.

Moreover, even if the British economy is severely supply constrained this doesn't excuse the Chancellor's policy of extreme fiscal consolidation. There is clear evidence that his policy has taken demand out of the economy. Are the Chancellor and his supporters really seeking to argue that without fiscal consolidation there would have been excess demand and runaway inflation?

The evidence is that his policy has weakened the British and Scottish economies.

In what one might call a 'moderate' or middle-of-the-road assessment, Gavyn Davies and Juan Antolin-Diaz in a Fulcrum Research Paper estimate that "fiscal austerity" since 2010 has accounted for almost half of the shortfall in UK GDP relative to the US since 2007 - see chart below. The other main contender is the UK's weak export performance. And this latter has particular resonance for Scotland.

Davies and Antolin-Diaz assume a fiscal multiplier 0.5 in 2008-2009 and 0.7 in 2010-2012. This is below the range of 0.9 to 1.7 suggested by the IMF in its recent Economic Outlook and below the figure of 2 suggested in the recent US research noted earlier. On this basis the impact of fiscal austerity will be even greater than Davies and Antolin-Diaz's estimates.

But don't expect to see an acknowledgment of any of this amidst the smoke and mirrors of today's Autumn Statement.

Little joy in latest GDP data

Today the Scottish government published GDP data for the second quarter and the ONS published jobs and unemployment data for quarter June - August.

On any criteria, the new data do not make encouraging reading, with output falling, the number of jobs contracting and unemployment rising.

In this post, I shall focus on GDP and output, leaving a discussion of the labour market to a later post.

GDP in constant prices fell by 0.4% in Scotland during the quarter, the same loss of output as in the UK. We currently have available only the rounded data but on that basis we get the following chart

Both the Scottish and UK economies have contracted for the last three quarters. This is clear evidence of a recession, although thankfully not as steep as 2008-09. We wouldn't expect it to be as steep of course. Because what we are experiencing is effectively an aftershock of that Great Recession.

Over the year, the Scottish economy has experienced zero growth compared to slight growth of 0.4 per cent in the UK. It seems unlikely that there will be much improvement in that annual growth by the time we reach the end of the year, unless there is a mini-boom in output in the second half of the year. However, all the indications are, from surveys and casual empiricism, that that will not happen.

One issue that stands out from the latest Scottish data is the weakness of the production sector here. Output fell by 3.8 per cent compared to a fall of 0.7 per cent in the UK. The key reason for this was that the performance of Scottish manufacturing weakened considerably in the quarter and that was mainly due to a fall in production in the engineering sector, specifically Electronics (-5.5%), Textiles, Leather & Clothing (-3.8%), Other Manufacturing Industries including Repair (-3.1%), and Refined Petroleum, Chemical & Pharmaceutical Products (-2.4%).

The service sector did a little better here (+0.2% against -0.1% in UK) and construction bounced back (+2.0% against -3.0%) from the large fall experienced over the year. But, on an annual basis both services and construction have performed less strongly here than in the UK as a whole.

A final point on output is that the Scottish recovery is flattered by the statistical quirk that the UK figures include all of oil production whereas the Scottish data do not. With oil production weak this has affected the Scottish-UK GDP relative as John McLaren at CPPR pointed out as I reported here. As the chart excluding oil and gas production, and incorporating the latest data, shows, the Scottish recovery from the Great Recession has been weaker than the UK.

We are still a little over 4 per cent below the pre-recession peak in early 2008 with the UK still 3 per cent below.

On the latest evidence it will be many quarters yet before we return to that peak. And readers of this blog know why!

(More detailed analysis of Scottish GDP, the labour market and future prospects will be provided in the Fraser of Allander Institute, Economic Commentary, which will be published on 7th November.)

 

Barclays

I couldn't possibly comment!

The Krugman-Layard Manifesto

I support the Krugman-Layard Manifesto and urge others to do so.

Krugman and Layard in today's Financial Times suggest that

As a result of their mistaken ideas, many western policy makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s. It is tragic that in recent years the old ideas have again taken root.

With the crisis well into its fourth year, Scottish GDP remains 4 percent below its pre-recession peak, employment is 3 percent below, the ratio of employment to working population is nearly 6 per cent below, and unemployment at 8.2 percent is significantly above the pre-recession peak of 3.9 per cent and the 5 to 6 percent range that economists believe is associated with stable inflation.

Fiscal austerity isn't working. The evidence is overwhelmingly against it producing an expansionary effect on GDP. It is making the crisis worse.

Sign the manifesto here.

Oil and GDP Growth

The Centre for Public Policy for Regions (CPPR) yesterday produced an important comparison of UK and Scottish GDP growth in 2011. The analysis uses the latest Scottish Government GVA data for the 4th quarter of 2011, which were published on 18 April.

A key finding of the CPPR analysis is that a comparison of overall GVA between Scotland and the UK in 2011 provides a distorted comparison of the relative performance. This is because overall GVA includes all of North Sea Oil and Gas production in the UK figure but only includes on-shore activities in the Scottish figure. A more correct comparison is to compare GVA for the two excluding the extraction of oil and gas.

Normally this matters little if the performance of oil and gas is not much out of line with overall performance. But during the past year oil and gas production fell by 18% and 22% respectively, which has affected UK GDP and export performance as I noted here and here.

The effect of this fall is to dampen UK growth relative to Scotland.

In 2011, overall GVA grew by 0.5% in Scotland and 0.6% in the UK. But when oil and gas extraction is excluded the unfavourable gap between Scotland and the UK widens, with Scottish growth of 0.5% and UK growth of 1%.

I have taken CPPR's analysis further and extend the comparison back to the start of the recession and subsequent recovery. The performance of overall GVA is given in this chart:

And GVA performance, with oil and gas extraction excluded, is given in the next chart:

The charts reveal the dampening of UK growth relative to Scotland when overall GVA is considered. When oil and gas extraction is excluded the Scottish position is broadly unchanged but the UK recovery is stronger.

The main conclusion from this analysis is that the Scottish recovery from recession is quite a bit weaker relative to the UK than many might have believed.

Alternatives to Austerity

There is increasing evidence - see here and here - that austerity policies have been a failure in promoting an expansion of GDP as well as reducing high levels of government deficit and debt. These findings are buttressed by academic research - this blog by Simon Wren Lewis - that suggests that high government debt levels should be cut slowly.

The logic of this evidence is that a reversal of austerity policies, for a temporary period at least, should be introduced to encourage actual GDP to recover. Only, when GDP is expanding at trend or above and the economy is close to its NAIRU, or 'natural' rate of unemployment, should policies to reduce government's structural deficits and hence debt be introduced. Even then the speed of adjustment is still critical.

An objection to this approach reflects a fear that the financial markets would turn against the sovereign state that started to do this. The markets might refuse to buy its bonds or seek an ever greater risk premium. Hence, the fear that long-term bond yields would rise and the costs of financing government debt become punitive. But this view assumes that current low bond yields reflect financial market confidence in austerity policies. In fact, the evidence - see Jonathan Portes here - suggests that yields are low because the UK economy and the recovery is weak.

Moreover, financial markets also know that states that are monetary sovereigns i.e. have their own currency and a central bank able to print the currency, will not default on their debt unless by choice. This is one reason, at least, why the UK and the US are in a very different position from France and the periphery countries of the Eurozone.

Despite this, the concern about rising government debt levels has led many commentators to seek alternatives to debt financed fiscal expansion as the basis for their "Plan B".

Simon Wren Lewis makes clear here and here that in such a situation a balanced budget multiplier approach is an appropriate solution. Here a temporary increase in public spending is financed by an increase in taxes of equal amount. In simple economics, an increase in public spending of £1 raises demand by £1. Aggregate demand is raised because taxpayers draw some of their increased tax payments from savings as well as reduced consumption. The taxpayer pays more in taxes but this is offset by higher income. The balanced budget multiplier equals 1 and can be greater than one when interest rates are stuck at zero - as in current conjuncture. This is because any rise in expected inflation due to the demand stimulus will lower real interest rates and so stimulate activity further.

Indeed, as Simon further argues a stimulus effect can be secured without an increase in taxes as well as without further borrowing.

There is the option of tax and transfer switches, within a given tax burden, whereby taxes are cut/raised or transfers raised/cut for those groups with high/low marginal propensity to consume. Re-directing transfers in favour of the unemployed or those in receipt of benefits would be one possibility as I noted here. Simon also suggests ways in which a tax increase can be avoided: a debt financed stimulus can be reversed by lower public spending in the future and not by higher taxation.

A fiscal stimulus can also avoid higher taxes and increased borrowing by a monetary sovereign financing the temporary expansion through new money as Brad DeLong makes clear. I believe this would require legislation in the UK. But it seems to me that it would be a lot more effective than the current programme of quantitative easing (QE). The Bank of England could use sales of securities to lower the money supply once recovery was under way and the obstacle - to monetary policy - of the zero interest rate bound removed as rates rise.

At this point it seems appropriate to dismiss an "alternative" to austerity proposed by George Kerevan in the Scotsman on Friday. Kerevan notes that the Bank of England through its QE programme has built up large holdings of long-term UK government securities through secondary purchases from the private sector. He contends that

If the Treasury and the Bank of England agreed to cancel these bonds, the national debt would fall miraculously to a mere 41 per cent of GDP – very low by any standards. Plus government spending would be slashed by £18bn a year. That would cut this year's planned borrowing by 15 per cent. Alternatively, it could provide precisely the fiscal boost needed for growth – without adding to borrowing.

Unfortunately, it won't do anything of the sort. First, before QE, the interest payments of £18bn were being paid to the private sector, so redirecting them is not going to have that much expansionary impact unless it is along the lines of the tax/transfer switches noted above. Secondly, after QE, the £18bn interest or dividend payments are paid to the Asset Purchase Facility which is indemnified by the Treasury and is part of the public sector. The situation was clearly stated in the speech on QE by Charles' Bean, Deputy Governor of the Bank of England, in October 2009:

Any profits on the Asset Purchase Facility are passed to Her Majesty's Treasury, while any losses are also indemnified by the Exchequer. The accounts are therefore not consolidated with the Bank's own accounts, as the Bank has no economic interest in the fund.

.... gilts held in one part of the public sector, the Asset Purchase Facility, are just a liability of the rest of the public sector. In the accounts for the rest of the public sector, there must therefore be offsetting interest flows, as well as corresponding capital gains or losses,

.... whether the Treasury ends up with a profit or a loss from the Asset Purchase Facility represents only a small part of the picture. Gilt yields will be lower than they would otherwise have been during the period that they are held in the Asset Purchase Facility, so reducing the cost of financing a given budget deficit. This needs to be factored into any calculation of the implications for the public finances.

There are alternatives to austerity. There are alternatives to a debt financed stimulus and there are alternatives to tax financed stimuli. But there is no 'novel solution' to debt finance along the lines suggested by George Kerevan.

The Language of Growth

It is now being suggested that proponents of pro-growth policies are gaining the upper hand against the austerity advocates in Europe and elsewhere. But proponents of "growth" policies need to be careful. The problem we need to address is not a "growth" problem per se but one of a deficiency of aggregate demand. As I noted in this earlier post, in the context of the Scottish economy, the problem:

is a deficiency of overall demand for goods and services and hence jobs in the Scottish economy given the available quantity and quality of resources of the current workforce and the stock of plant, machinery and buildings. ..... the problem is not about "growth" in the strict sense of the term. Growth and growth policy is about increasing the quantity and quality of available resources in the Scottish economy. This is what economists call the 'supply potential' or 'supply capacity' of the economy. The current problem is not supply potential. There is plenty of that. .... (M)any of the criticisms made of the Scottish government and much of the response from the Scottish government are about policies that might improve the long-term supply potential or 'growth' of the economy. They are not about ways of improving the utilisation of existing capacity.

Advocates of "growth" policies in the present juncture need to watch their language.

UK GDP: don't panic, yet!

The latest UK GDP figures for the first quarter of this year revealing a fall of -0.2% should not lead to panic. Yes, we are now in technical recession after a fall of -0.3% in the final quarter of last year. The latest change is largely driven by Construction with Services contributing positively to growth and Manufacturing neither contributing positively or negatively. Production made a small negative contribution but this was due exclusively to a fall in Mining and Quarrying output of -3.6% due largely to the fall in oil and gas extraction. The contribution of broad sectors is shown in this chart:

The latest GDP data from the ONS are likely to be revised upwards because they reveal a much weaker picture than revealed by UK business surveys. The latest PMI construction surveys stand in marked contrast to the ONS data as this chart shows:

Business surveys generally appear to suggest that the slowdown noted at the end of last year is beginning to turn round see here, here and here. We should see some positive growth in the second quarter.

But it is going to be a hard slog.

None of this detracts from my view that we are enduring a weak recovery largely because of the UK Government's austerity programme. Gavyn Davies' recent FT blog charts the weakness of the UK recovery against the other G7 countries and the contrast is quite marked see chart:

Source: Gavyn Davies

He is more sanguine that the current UK policy mix favouring a much looser monetary and exchange rate policy than elsewhere but tighter fiscal policy may start to generate growth dividends in the future. I am much less sanguine because with interest rates close to zero - the zero bound - monetary policy effects on demand and growth are much weaker than in normal times.

In the meantime, UK GDP now stands at 4.3% below its pre- (2008) recession peak, austerity continues and the situation in the Eurozone has worsened again.

OECD forecast: gloom but not doom

The British media got quite excited this morning by the OECD's latest interim forecast. Many ran headlines such as "Britain back in recession". But as I note in a short article in today's Scotsman, the OECD's forecast is not something that we should get too excited about. The predicted 'recession' is minimal and not forecast to continue. Moreover, the published forecasting errors for the OECD model are quite large for the UK, with the OBR forecasts falling within the OECD error range.

The chart shows the OECD forecast for the first half of 2012 in annualised terms compared to the OBR. It is smaller than the OBR's forecast but still positive. So, no recession is forecast in any meaningful sense. The OBR forecast for the second half of this year is also included. There are no OECD forecasts for the final two quarters of the year because the interim assessment only looks forward two quarters. Now while the OBR are clearly more bullish than the OECD, the difference is only a matter of degree. In its November Economic Outlook the OECD said of the UK

Growth will start to pick up during 2012 as exports and household consumption recover, with further strengthening in 2013.

While things have softened a little since November, I doubt the OECD has revised that judgment.

We must beware projecting concerns about the effect of fiscal austerity onto each piece of data or forecast that emerges. The recovery continues to be weak and that is due mainly to fiscal austerity. But that warrants gloom not doom.

The price of austerity?

The latest revision published by the ONS today shows that UK GDP fell by -0.3% compared to -0.2% in the two previous estimates. This new information doesn't tell us much except help confirm the weak recovery. GDP now stands just over 4% below its pre-recession peak after a peak-to-trough fall of more than 7% in the recession. The US in contrast attained its pre-recession output peak in the second half of last year. So why has the recovery in the UK been so much weaker than in the US? Adam Posen, the US external Member of the Bank of England's MPC has essentially one answer: the UK government's fiscal austerity programme. There are other differences between the two economies that led to a slower recovery in investment and consumption in the UK. These include a poorer allocation of credit in the UK, the greater spillover of risk from the euro crisis and bigger impact of energy price rises. But they pale when compared to fiscal austerity. Posen estimates that

Cumulatively, the UK government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households.

An examination of the GDP data shows that the recovery began to weaken in the third quarter 2010 a few months after the Conservative-Lib Dem coalition came to power and Osborne's June emergency budget when £6 billion was immediately taken out of the economy. For budgetary reasons, Scotland's share of this cut was postponed until the next financial year. The charts below show what the recovery would have looked like if the pre-2010q3 recovery had continued in both UK and Scotland.

These charts suggest that both the UK and Scotland would have attained their pre-recession GDP peak in the second quarter of this year, not too long after the US. The estimates also reveal that to the latest data point UK GDP is 3% below where it would have been, in relation to the pre-recession peak GDP, if the earlier rate of recovery had continued. Cumulatively, that amounts to a 10% loss of GDP compared to the pre-recession peak. Is that the price we have had to pay for the UK government's austerity policy?