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.
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