Scottish Economy Watch

Sharpening up the act

There has been a flurry of statements in the last few days from business organisations, political parties and newspaper editorials urging the Scottish government to in the words of CBI Scotland "sharpen up its act" over the economy. These statements are in response to the weak performance of the Scottish economy and poor short-term prospects.

Scotland, is of course little different from most of the western world. The recovery is faltering as households and organisations continue to reduce their historically high levels of debt as asset prices have fallen. Moreover, the Eurozone crisis is further damaging business and consumer confidence, which is depressing demand for goods, services and investment goods further. Further evidence of the problem was provided by Lloyds TSB Scotland quarterly Business Monitor (no link), conducted by the Fraser of Allander Institute at the University of Strathclyde. Key findings were the large drop in export demand, net falls in company sales and falling business and consumer confidence.

Hence, the need, according to the statements, for the Scottish government to "sharpen up its act."

This begs the question what reasonably can we expect the government of Scotland to do. To answer this question we must ask what the problem is before we consider how best to address it. The problem? This clearly 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. So, the first point to make is that 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. GDP is still probably around 10 percent below where it would have been in the absence of the recession that we are recovering from. Accordingly, many 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.

To improve the utilisation of existing capacity, the demand for goods and services produced in Scotland needs to be increased. This is more difficult for the authorities of a small open economy, no matter whether it is a sovereign state or a 'region' of a larger state or monetary union. The two charts below show the composition of final demand for goods and services in Scotland and the UK in 2007.

What is clear from the charts is that exports are more significant to Scotland, at 30% of final demand, than they are to the UK, 21% of final demand. So, the demand for Scottish products is more dependent on factors outside its borders than is the UK. Government consumption amounts to the same percentage of final demand, 16%, in Scotland as in the UK. However, it is clear that the level of government spend in Scotland is determined by the block grant to the Scottish Parliament, which is determined by the Barnett formula, and spending by UK government departments in Scotland. The UK government is undertaking, for better or worse, a programme of fiscal consolidation and so both government consumption and the proportion of capital formation that is spent by government, is reducing. Again, this is out of the hands of the Scottish government. This need not mean, of course, that this justifies Scottish independence because the unknown counterfactual of that state could involve Scotland with lower or higher government revenues and spending, and its own programme of fiscal consolidation. Nobody knows.

So, to focus on what the Scottish government can do to stimulate demand immediately or in the near future, the options are limited. It can try and divert or switch some government spending to areas where the multiplier is higher. That is where it will be more fully spent in Scotland and not saved or used for imports, or reduce the burden of hiring extra workers that is, reduce the marginal cost to businesses of adding employees. Clearly, targeting the unemployed is one of the best options - see this earlier post - but there are few levers available to the Scottish government to reduce the marginal cost to firms of adding employees. The government might also encourage Scots to spend more on locally produced goods by importing less and to save less. But the former runs the risk of retaliation from other countries and the latter would be difficult to achieve. Finally, some emphasise spending on capital infrastructure. While this will certainly add to capacity and help with growth in the long-term, such projects take time to get up and running. Moreover, as the CBO evidence shows in my earlier post, the return in terms of full-time jobs per pound spent is not high.

So we see that if the proper focus is raising demand in the Scottish economy in the here and now, the policy options available to the government of a small open economy, in current circumstances, are much more limited than some might think.

Outlook for 2012

David Bell has a good article in the Scotsman today on the outlook for the Scottish economy in 2012 and the pitfalls we may confront along the way. I agree with almost everything he says. The Scottish economy will like the UK and the rest of Europe be weak in 2012. David suggests that

Output in Scotland and in the UK as a whole have moved closely together since the beginning of the recession. There are no compelling reasons to expect divergence in 2012. The average City forecast for UK output growth in 2012 is 0.6 per cent growth. If this is accurate, then Scotland is likely to experience another year of anaemic growth.

The only caveat I would make is that while Scottish output has moved closely with the UK since the recession the fit is not exact. UK GDP has come back somewhat more strongly than Scotland, as the chart shows, even though the recovery is weak overall.

A more competitive Scotland?

On 23 December the ONS published data on labour productivity in the UK for the 3rd quarter 2011. The release and supporting datasets also contain information on labour productivity across the UK regions compared to the UK between 2003 and 2010. As with earlier posts what is interesting from these data is the change pre recession and post recession. The charts show labour productivity in Scotland, measured by nominal GVA per filled job and nominal GVA per worked hour. Clearly, the number of hours worked can vary independently of the numbers employed, so both are useful statistics, with GVA per hour tending to be preferred by economists.

The first chart shows the track of Scottish labour productivity relative to the UK = 100 between 2003 and 2010.

The chart shows that in the years to 2007 labour productivity in Scotland remained broadly in the range 94% to 96% of the UK figure. However, after the recession, by 2010, labour productivity in Scotland had risen to parity with the UK on GVA per job and to just below the UK - 99.3% - on GVA per hour.

What explains the change?

The most obvious explanation is that the loss of jobs during the recession was relatively greater in Scotland than in the UK as a whole, while output held up better in Scotland. See this post and the November Fraser of Allander Institute Economic Commentary.

But, the lesser recourse to labour hoarding may not be the whole explanation.

The following charts show labour productivity relative to the UK across the UK regions before recession in 2007 and, roughly, at the recession trough in 2010.

From these charts it is clear that Scotland's relative position improved from 4th to 3rd in the regional rankings on both productivity measures. Specifically, Scotland overtook the East of England. An examination of the recent regional GVA statistics suggests this relative improvement to the UK and the East of England may have been due to manufacturing output - which tends to have higher labour productivity - holding up better in Scotland during the recession. In addition the financial services sector, another high productivity sector, held up better in Scotland than in East of England during the recession.

So, the tentative conclusion is that the improvement in Scottish labour productivity is due to a greater jobs shakeout and sector composition effects. These data cannot tell us whether the Scottish economy has become intrinsically more competitive than the rest of the UK. For that, we need data on labour costs and crucially information on changes in capital productivity. Unfortunately, data on multi-factor productivity is not readily available for Scotland, or the other UK regions.

Parallels are all too Depressing

My article in today's Scotsman on the parallels between the Eurozone today and the run-up to the Great Depression in the early 1930s is here.

For those interested I drew on the following sources. On the specifics of the Great Depression I used - ex-head of President Obama's Council of Economic Advisers - Christina D. Romer's article prepared for the Encyclopaedia Britannica which is here. On the mechanics of the Gold Standard I refreshed my memory by reading the relevant bits of International Economics by Paul Krugman and Maurice Obstfeld. On the dimensions of the Wall Street Crash I revisited John Kenneth Galbraith's The Great Crash 1929. I also had cause to re-read, with profit, Irving Fisher's classic article on The Debt-Deflation Theory of Great Depressions which is here. On the lack of a relationship between sovereign debt and bond yields outside the Eurozone I used the OECD data that appeared in this earlier blog. The data for the assertion that manufacturing held up better in Scotland during the recent Great Recession is here. The graph is below

On 'cheap money' policy in the 1930s and the lessons for today see Nick Crafts Delivering growth while reducing deficits: lessons from the 1930s.

The situation in the Eurozone is very fluid. It is only 24 hours since I wrote the article but I would now augment the comment I made about the need for the ECB to act as a full lender of last resort with the observation that it may now be doing so but sotto voce. Gavin Davies has an excellent recent post in the FT on this. Only time will tell if this undeclared policy will work.

Financial services and the recession

It is a truism that financial services in general and the banks in particular played a key role in the speculative bubble that led to the recent Great Recession. We know from the published Scottish GVA data that Scottish financial services contracted rapidly while output volumes held up better in the UK. Between 2007 and 2009 financial services real GVA fell by about 7% in Scotland, while GVA in UK financial service rose slightly by 0.3%. The recently published Regional Economic Activity (GVA) data allows us to analyse sectoral performance across the UK regions up to 2009. What is slightly surprising from these data is just how much the share of the financial service sector rose in each region between 2007 and 2009 - see chart.

These data are expressed in nominal terms. They show the share of UK financial services rising by more than 2 percentage points from 8% to over 10%, while its share in London rose by 4% points from 17% to 21%. The share of financial services also rose in Scotland from 7% of total GVA to 9%, despite the large drop in volume.

So, what is going on here? It is not clear. There may be some differences in the two data sources. There may also be the effect of timing as more volume was lost in the sector after 2009. But there is still a puzzle.

Is it because firms in the sector were able to push up prices and charges? Anecdotal evidence from many firms in receipt of loans suggests that that did happen. The Governor of the Bank of England is on record as being concerned about the lack of competition in UK banking and the funding of SMEs. But, on the other hand, competition in the sector is high from the evidence in international studies. For example, the UK ranked 11th out of 49 on a sophisticated measure (H statistic) of competitiveness of its banking system in Claessens and Laeven, 2004. Also a high degree of competition in banking can encourage excessive risk taking and cause problems similar to those that led to the credit crunch.

But still there is a puzzle here. Anyone got any views?

UK 3rd quarter GDP revision

Today's release from the ONS revised up the estimate of UK GDP growth in the third quarter to 0.6%, but revised down second quarter growth from 0.1% to zero. The first release reported real GDP growth of 0.5% in the third quarter which was above the anticipated 0.3%. However, the special factors that temporarily reduced growth in the second quarter: the Royal wedding; two bank holidays; and the effects on supply of the Japanese Tsunami, have now unwound, so that the ONS recommended that the second and third quarters should be taken together. On that basis growth averaged 0.3% in the two quarters, with real GDP still largely stagnant over the past year.

Nevertheless, this is slightly better news amongst a plethora of recent bad news about the economy, notwithstanding the downward revision in the second quarter.

Looking at the contribution to growth of the main expenditure components - see first chart - we see growth was largely the result of firms adding to their inventories. This might be a good omen that firms were anticipating increases in demand in the future e.g. additional demand at Christmas, and so were preparing for it by adding to their stocks. However, seasonal adjustment of the data should have removed that effect unless it was out of the ordinary. The negative interpretation is that there was a shortfall of demand, firms had produced too much and so added to their inventories. I fear that is the most likely explanation. If that is correct we might expect to see flat, or even slightly negative, growth in the fourth quarter.

It is also reassuring to see some pickup in fixed investment, which made a small contribution to growth in the quarter. But household demand remains very weak with no contribution to growth in the quarter and the savings ratio rising again - see chart. And net trade made a negative contribution to growth. If anybody needed reminding the UK government predicated the economic recovery on strong growth in exports and investment.

Government consumption made a negligible contribution. The ONS notes that this reflects the continued squeeze on expenditure.

The ONS sums up with this cautionary note:

The profile of GDP growth in recent quarters continues to point towards a rather fragile economic picture. During the nine quarters of the recovery, the economy has gained just over half of the output lost during the five quarters of contraction.

A short-term fiscal Stimulus

Back in November I argued in the Fraser of Allander Institute's latest Economic Commentary that the sluggishness of the UK and Scottish recoveries meant there was still scope for some fiscal easing without damaging our fiscal credibility in the long-term. When pressed later by journalists on what specifically should be done I mentioned raising unemployment benefits and cuts in national insurance. The former because household in receipt of unemployment benefit would almost certainly go out and spend it quickly (Technical: the households have a high current marginal propensity to consume). The latter because it would inter alia reduce the marginal cost to firms of hiring additional labour.

The argument for increases in unemployment benefits was met with hostility in comments from Scottish business organisations and in some letters to newspapers from supporters of the UK government's current austerity policy.

Here is some supporting evidence from the Congressional Budget Office (CBO) of the United States in testimony to the Committee on the Budget of United States Senate on 15 November 2011. See chart:

The CBO conclude that

• Policies that would have the largest effects on output and employment per dollar of budgetary cost in 2012 and 2013 are ones that would reduce the marginal cost to businesses of adding employees or that would be targeted toward people who would be most likely to spend the additional income. Such policies include reducing employers' payroll taxes (especially if limited to firms that increase their payroll), increasing aid to the unemployed, and providing additional refundable tax credits in 2012 for lower- and middle-income households.
• Policies that would primarily affect businesses' cash flow but would have little impact on their marginal incentives to hire or invest would have only small effects. Such policies include reducing business income taxes and reducing tax rates on repatriated foreign earnings.

But the CBO warn that

If policymakers wanted to boost the economy in the near term while seeking to achieve long-term fiscal sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it later in the decade.

Hitting the buffers

This week the ONS published Regional Economic Activity (GVA) data for the UK. The release contains much interesting information on annual GVA, employee compensation and gross operating surplus/mixed income, on a residence and workplace basis, by region and sector, in nominal terms. Unfortunately, the data only go up as far as 2009. Nevertheless, the data offer some interesting insights into the incidence of the Great Recession.

The data reveal, as would be expected, that the public sector acted as a buffer in all NUTs 1 regions as the growth of nominal income slowed and in some cases fell, between 2007 and 2009. See chart which shows shares of the 'public sector' in regional GVA in the two years.

Broadly, those regions which depend more heavily on the public sector and/or where manufacturing is important, such as Northern Ireland, Wales, the North East, West Midlands and East Midlands, experienced the greatest increase in their public share as the recession started to bite. Manufacturing was hit strongly during the recession.

It is therefore tragic that those regions that had to rely the most on the public sector as a buffer during the recession are now being hit badly by Cameron and Osborne's austerity programme. There's a lot more analysis to be done here, but the current pattern of unemployment rates goes some way to support that story - London is affected, I think, by a difference between resident (unemployment) and workplace (GVA in this example) indicators.

Oh, and what about Scotland? Its middling position is, I suspect, due to a relatively lesser reliance on the public sector as a buffer in the recession - its share rose by a little over one percentage point in Scotland compared to a rise of nearly four percentage points in the North East. Moreover, manufacturing held up better in Scotland, with its share of the Scottish economy remaining largely unchanged at between 11% and 12%. But in the North East the share of manufacturing fell by nearly two percentage points to just above 13%.

Bond yields, debt and prosperity

At Prime Minister's question time yesterday the Prime Minister said in response to a question from Ed Miliband that

"It is this Government who have got interest rates down to 2%—that is why we have the prospects of growth."

What the Prime Minister was presumably suggesting was that the current low yield on Treasury 10-year bonds is the consequence of the Coalition government's programme of fiscal consolidation. The aim of this policy is to reduce the large structural budget deficit, which is leading to higher levels of government debt. So, the UK government argue that the willingness of the financial institutions to lend to the British government has been enhanced by the programme of cuts in public spending and some tax rises. Ministers often contrast Britain with Greece, or Italy, suggesting that if we don't continue with the programme of fiscal consolidation our debt level will remain high. A continuing high debt level, they argue, will lead to the market flight and high bond yields currently observed in those two countries. The high long-term bond yields would, in turn, divert large amounts of public spending from socially and economically productive uses into interest payments on the debt. They may also raise the borrowing costs for private sector investment, so dampening investment and growth.

Is the government's view correct? Has fiscal consolidation led to a lowering of bond yields? And, more generally do high levels of government debt lead to high bond yields?

The first chart shows the path of 10-year UK Treasuries since 2007.

What is clear from the chart is that UK 10-year yields have been falling since 2007? Why? Probably because of the weakening of growth in the economy. When the financial markets expect low growth and low inflation, they tend to move out of equities and into fixed interest securities or government bonds. Government bonds act as a safe haven in time of economic trouble. The chart does show a fall in the yield during 2010 and some of that might have been due to the fiscal consolidation plans of both Labour and then the Coalition government which came into office in May 2010. But from the third quarter of the year yields began to rise again until the first quarter of 2011 as expectations of economic recovery rose. After the first quarter the 10-year yield began fall fairly quickly. But this fairly clearly was not due to fiscal consolidation, because there were no new announcements. Indeed the signs were that the UK economy was slowing and that there was an increased risk of failing to meet the deficit and debt reduction targets.

Two things were happening. First, economic growth was slowing across much of the developed world and secondly, the Eurozone crisis began to worsen. The ECB pushed interest rates up in April and again in June, both decisions were viewed by many economists as mistaken because the inflation risk was negligible. The interest rate rise increased the risk of a slowdown in growth in the Eurozone and hence increased the attractiveness of government bonds. Moreover, the risk of liquidity and solvency problems in Greece, Portugal, Ireland and Italy meant that a self-fulfilling flight was beginning away from peripheral country Eurozone bonds.

But is it legitimate to argue that just as there was a flight away from peripheral Eurozone bonds, so there would also have been a flight away from UK government bonds if the markets expected UK debt levels to remain high? In other words, while low growth may lead to financial markets switching away from risk assets such as equities towards government bonds would they only switch to bonds of countries where the debt was low, or was falling?

The answer to these two questions is, no! The reason is that the risk of insolvency is appreciably greater in countries with high levels of government debt and where borrowing is effectively in foreign currency and there is no own central bank. In countries such as the UK with their own currency and central bank, the central bank acts as a lender of last resort and can also print money to pay creditors. This may, through the risk of higher inflation, reduce the potential real value of the debt to the creditor and that is likely to be preferred to a complete default.

So, for countries with their own currency and central bank we should expect that there is little or no relation between government debt levels and bond yields. This is what the data show as indicated by the next chart.

The non-Euro countries are in black and there would appear to be no relation. There is something of a positive relation between debt level and bond yields in the peripheral Euro countries but nowhere else.

We can therefore conclude that there is little evidence to support the UK government's contention that fiscal consolidation has delivered low government bond yields and the prospect of greater future prosperity. Rather the imposition of an austerity regime threatens lower prosperity and only through that route a reduction in bond yields, while the reduced growth means that deficit and debt targets may fail to be met.

The curse of unemployment

Further thoughts on today's labour market figures. Unemployment is a curse on the individuals and families that are subject to it. On the ILO definition there are now 228,500 people unemployed in Scotland, or 8.5% of the workforce. This number is very close to the peak of unemployment in the recent Great Recession when unemployment reached 236,819 (8.8%) in May – July, 2010. And, unemployment is now still 123,000 higher than it was at the last trough, or low point, of the unemployment cycle when it fell to 105,326 (3.9%) in March – May 2008. See chart

Moreover, unemployment affects different groups in the population differentially, with some being more hurt than others. At the present time it is young people that are being badly hit. The Scottish government today published supplementary data on youth unemployment. These data show that in Aug – Oct 2011 the unemployment rate was 23.5% compared to 20.5% in the UK as a whole. 93,000 young people are unemployed in Scotland, that's 41% of total unemployed. Many of these young people may not have worked before and may have yet to develop basic work skills. Others recently into the labour market are likely to be demoralised by the rejection. At a simple economic level this may be contributing to a lowering of the output gap and lost future production. At the individual and social level we are watching a tragedy unfold of major proportions, which no civilised society should tolerate.