Yesterday, the Ernst & Young Scottish ITEM Club published its latest forecasts for the Scottish economy. These forecasts echo our own published last month. GDP growth is forecast to be 0.6% this year and 1.1% in 2012. The Fraser of Allander forecasts were 0.4% for this year and 0.9% for next. Both bodies have made significant downward revisions to their forecasts in the light of the weakening recovery. Both also assume that the Eurozone muddles through its present crisis and acknowledge that a sovereign default by either Italy or Spain would push Europe and the UK back into recession or worse. The Scottish recovery is noted again by both bodies to be weaker than the recovery in the UK, with the performance of manufacturing, transport and communication & business services relatively weak here. The weakness of Scottish manufacturing exports is particularly evident. ITEM rightly note that Scottish GDP in mid-2011 was no higher than in 2006, when on past trend growth performance one would have expected GDP to have been ten percent higher over five years. They suggest that this supports the notion that we may be facing a 'lost decade' of output and income growth.
The ITEM report also makes the point that the current economic malaise may be affecting our long-term growth potential. This echoes the recent Office of Budget Responsibility Economic and Fiscal Outlook report, which concluded that the gap between actual and potential output in the UK in the third quarter of this year was 2.5%, smaller than appeared to be the case a year ago. A smaller output gap means that there is less room for real expansion through, say, a fiscal and/or monetary stimulus. That also means that the government's structural deficit may be bigger than previously thought. So, the Coalition Government has concluded that more fiscal austerity is necessary.
But the policy decision to tighten further is built on slender foundations. The OBR's statistical work may suggest that the output gap is smaller but they can offer no clear reason why this is so. Instead they cite an IMF report which they claim
suggests that an impaired financial sector can lead to low productivity growth and that downturns associated with significant disruption to the financial sector are often characterised by large and persistent output losses. (Page 54).
But as Paul Krugman points out, the OBR fails to acknowledge that the same research report also effectively says that short-run fiscal and monetary policy stimuli tend to limit the damage to long-run growth potential of such crises. Added to this is the clear risk that the present fiscal consolidation and the new measures announced in the Autumn Statement will depress aggregate demand further. Hence tax revenues will fall and expenditures on transfer payments will rise, so that attainment of the deficit target moves further into the future, requiring, in the government's view, further fiscal austerity .....
Such is the basis for UK macro-policy these days.
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