Scottish Economy Watch

Music for the vacation: Admiral Fallow

I shall be away on leave until Monday 16th April and since I shall be travelling a bit there will be little or no posts. Enjoy another great Scottish musical outfit while I'm away.

Eurozone crisis: mainly macro but partly regional

In another very good post today Simon Wren Lewis raises the issue of whether European austerity is self defeating. In the course of his piece he makes the point that

a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.

However, that is only part of the story. We need to look at economies of the Eurozone as illustrating problems of regional imbalance as well as macro imbalance.

The creation of the Eurozone created one 'national' economy and set up in consequence regional adjustments to the adoption of a single currency which are continuing to work out to this day. The weaker periphery had lower labour productivity and lower wages and that encouraged capital flows from the core countries, mainly Germany, to the periphery. As I wrote in this earlier post

the creation of the Eurozone made it more attractive for investors in the rest of Europe to buy assets in the peripheral countries, where there were, on the face of it, significant investment opportunities. …. These capitals flows worsened an already weak and worsening current account trading position in the periphery because of the high exchange value of the Euro driven by continuing improvements in German competitiveness. Several of the periphery countries such as Greece, Portugal and Spain had, and still have, real efficiency and competitiveness problems, which make it difficult for them in a monetary union led by Germany that has high levels of productivity growth. One saving grace might have been if these investment flows had facilitated an economic adjustment in the periphery sufficient to raise their productivity and competitiveness towards German levels. But they did not, even though the evidence shows …. That the capital flows were associated with investment spending rising in the periphery countries (with the exception of Portugal) relative to consumption.

What we were seeing here is a regional adjustment process that appears to have some of the properties of the regional neo-classical growth models as first considered by George Borts. In these models the returns to factors are eventually equalised as capital and labour flow across regions towards higher marginal returns. Given the production function assumptions, regions with low marginal returns to labour/high marginal returns to capital will attract in flows of capital. Labour will flow in the other direction to higher marginal labour returns. During this process GDP per head should grow more quickly in the regions attracting capital.

The chart below shows a hint of this process after the creation of the Eurozone.

The countries are ranked by ascending GDP per head in 2000 from left to right and the chart shows the growth of GDP. Ireland should really have GNP per head because of the large leakage of multinational profits. Once that is allowed for there is some suggestion that parts of the lower income per head periphery, especially Greece, grew more quickly than the core, especially Germany.

Clearly, other factors such as the differential regional incidence of economies of scale, agglomeration economies, accessibility to markets and other production conditions will have prevented the traditional neo-classical adjustment process. But there is an indication that some convergence was occurring after the creation of the Eurozone, which was halted by the sudden stop of the credit crunch.

What are the implications of this?

It suggests that country/regional adjustment within a single currency area need not simply be about managing aggregate demand differentially. There is a role for stronger regional/cohesion policies to support and effect a more rapid adjustment. Of course these processes take time. Perhaps more time than is available to Greece, Portugal and Spain. But we should not let policy ignore a key economic adjustment process that might help mitigate the pain of contractionary macro-policies in the periphery.

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?

Devolution and Fiscal Policy

As I noted in my previous post, devolution can offer fiscal policy options that are just as credible as the policy mix that would be available under independence. And these options could be available without some of the costs of independence.

Let us be clear what I am talking about here when I refer to 'fiscal policy'. By fiscal policy I mean the use of variations in tax rates, tax bases, tax instruments, spending mix and spending levels to achieve economic policy objectives. These objectives can be stabilisation, growth and distribution. I focus on stabilisation here leaving growth and distribution for later posts.

The target of stabilisation is usually a level of GDP, and employment where there is no economically usable spare capacity in the economy. That is, where the output and unemployment gaps are small, or close to zero, and unemployment is almost wholly 'structural'. More technically the economy would be at the Non Accelerating Inflationary Rate of Unemployment (NAIRU), currently estimated in the UK to be around 5% of the workforce. Scotland's NAIRU should be similar.

It is broadly accepted by economists that in 'normal' times - i.e. when interest rates are not at a lower or zero bound - that a sovereign state with its own currency would tend to use monetary policy to meet its stabilisation objectives. However, when nominal interest rates are close to zero then monetary policy is much restricted and the burden of stabilisation as Simon Wren Lewis notes falls onto fiscal policy. Now for sovereign states and regions that are part of a monetary union the position is much the same. Monetary policy is not available at the level of the state or region. Fiscal policy becomes the only tool to realise stabilisation objectives.

Is there evidence that fiscal policy can influence the level of GDP at the individual state and regional level within a monetary union? The answer to this appears to be, yes. See this post and chart from Paul Krugman

The chart shows the relationship between changes in real government consumption and changes in real GDP as share of initial real GDP in eurozone states. Krugman acknowledges that for some states observed here the causation might run from GDP to government spending as a consequence of the credit crunch, but two conclusions would appear to follow.

First, the austerity view that cutting government spending raises GDP does not appear to be supported - note this graph does not show full fiscal changes because tax changes and transfer payments changes are not accommodated. Secondly, within a union and where states have a high degree of fiscal autonomy, the possibility of using fiscal policy to influence GDP change seems real.

What does this say about Scotland?

Well, first, it suggests that an independent Scotland as an accepted part of the UK sterling monetary union should be able to adopt a different fiscal policy stance to stabilise GDP than rUK. However, it also suggests that providing the degree of fiscal devolution is sufficient to allow changes in tax and spend that can influence aggregate demand then this option is also available within the UK political union. Further academic research is required on the appropriate form and degree of fiscal devolution for effective stabilisation but there is little doubt that stabilisation at the level of nations and regions within the UK is feasible.

Moreover, if an independent Scotland is part of the sterling monetary union the Bank of England and rUK government will almost certainly require that the Scottish government abide by a set of fiscal rules - see this earlier post. The fiscal framework could be little different under devolution from that under independence. Under devolution, Scotland could have a separate stabilisation policy as well as the benefits from the risk pooling arrangements e.g. social security, bank bailouts etc. that are available as part of the UK. It is true that the high levels of trade with the UK would make it difficult for fiscal policy to chart a radically different stabilisation path from rUK but that would apply to an independent Scotland too.

And the moral of this story?

Scotland does not have to accept a Tory-Lib Dem austerity policy. But it doesn't have to leave the UK political union to do so.

Mr Salmond's Fiscal Plan

Yesterday's article by the First Minister in the Sunday Times (no link) on fiscal policy contained much with which I agree but also there was much to challenge.

He is surely correct to criticise the UK coalition government's fiscal authority programme as an

ideologically driven approach (that) goes too far, too fast.

Although, when Mr Salmond charges his opponents as being "ideological" I think of pots and kettles.

He is right too to argue that the UK government's austerity policy has stifled growth. We just have to note that the US economy attained its pre-recession GDP peak last year, whereas UK GDP is still just less than 4% below its pre-recession peak. It is true US GDP contracted by less during the recession, around 5% compared to 7% in the UK, but the main difference affecting recovery is an austerity policy in the UK but not - at least to the same extent - in the US. See Paul Krugman here.

I am also pleased that he seems to have adopted Bill Howatt's and my suggestion for a fiscal council in an independent Scotland! However, as is usual with many of Mr Salmon's economic pronouncements on an independent Scotland he gives us the esteemed names of the economists involved, or cites their 'support', but often as a substitute for an explanation of the how and the why. The subliminal message seems to be "internationally renowned experts are involved so independence must be a good thing" and "with such people involved you don't need to worry about Scottish independence." Given that the Scottish people clearly do need reassuring about the prospects for the economy under independence maybe that is a rational strategy on the part of the SNP. But if it is also a tactic for avoiding giving answers to tricky questions about the economy and economic policy post-independence then it should be exposed as such by continuing to ask the questions anyway.

Mr Salmond sees his "four internationally renowned economists" as forming a fiscal commission working group to

oversee the detailed technical work by civil servants on the fiscal and macroeconomic architecture around Scotland's public finances following independence, including the establishment of a credible fiscal commission which entrenches financial discipline and ensures market confidence.

To be effective a fiscal council/commission needs to be independent of government. Mr Salmond should commit to that now. He also should go further and ask his, hopefully independent, fiscal commission working group to begin by examining the veracity of claims such as those in the First Minister's article that

The latest Government Expenditure and Revenue Scotland publication for 2010-11 shows Scotland with a lower deficit to the UK as a whole. ... Relative to the UK as a whole, Scotland was in a stronger financial position to the tune of £510 for every man, woman and child.

As I showed in this earlier post the basis for this claim is simply that when Scotland gets a geographical share of oil revenues in 2010-11 it would be less worse off, or would have gone less into debt, by the £510 per person than the UK. This is not money in the Scottish peoples' pockets or the annual fiscal dividend from independence. Indeed, with oil revenues set to decline as production and the tax take falls faster than the likely trend rise in oil prices, the position is likely to reverse. Then, heaven forbid, we shall no doubt hear supporters of the Union making the same claims.

What we need is an independent body to examine such claims. A fiscal commission would be the place for that or Mr Salmond's fiscal commission working group pro tem. Failing that we need an academic body, or research team, to be resourced to provide the independent analysis.

A final point that needs to be remembered here is that Mr Salmond will tend to conduct the debate about independence and specific policy options by a black and white contrast between an independent Scotland and current policy in the UK under the Conservative-Lib Dem coalition. Of course, the status quo is not the only, or likely, counterfactual to independence. The UK can clearly have a left of centre government which would adopt different economic policies. But more relevantly, the options of further devolution with significantly enhanced fiscal powers means that much of the alleged benefits of independence for economic policy may be available without some of the likely costs of independence. Mr Salmond would like you to forget that.

I plan to post more on the costs and benefits of further devolution versus independence in the future.

Is Osborne "Browned" Off?

I suspect I am not alone in being a little disconcerted when I see images like this

Then when I read what the IFS said yesterday about the Budget

We do not know with anything like such certainty that the cut in the 50p rate will cost only £100 million. We do not know that the proposed caps on tax reliefs will bring in the £300 million or so the Chancellor is banking on. Nor do we know that the stamp duty changes will raise the nearly £300 million that he has pencilled in. .... (There is a) risk that Budget measures end up being a net giveaway.

And I remember this

I wonder if Mr Osborne is what he seems. Does this explain why Gordon hasn't been seen much around Westminster lately?

Regional pay: the first step to fiscal federalism?

It is alleged that Chancellor George Osborne and the Treasury plan to scrap national pay rates for some public sector workers in the UK. The reason? Well, public sector unions argue that the government is simply trying to save money and help it to reduce taxes on the rich. But the rationale given by the Treasury for the proposal is the variation in private sector salaries for comparable jobs across the regions of the UK. With public sector workers paid the same for similar jobs across the country the regional gap between public and private salaries varies considerably. So the FT notes that

The Treasury estimates that the so-called "pay premium" between public sector jobs and their private sector equivalents ranges from 0.5 per cent in the south-east to 18 per cent in Wales. ... Mr Osborne sees the move as a way of ensuring public sector pay reflects local market conditions and of avoiding private sector employment being crowded out in poorer areas of the country.

There is folly, insight and potential unintended consequences in Osborne's proposal.

The folly lies in the implication that lack of job creation in some regions of the UK is due to civil service wages being too high relative to private sector wages. At the present time the UK is labouring under a significant deficiency of aggregate demand with the unemployment rate at 8.4%. This is affecting all UK regions and nations. Some regions such as the North East are more affected by the drop in aggregate demand hence their high unemployment rates. Because of this the rate of growth, and possibly the level, of private sector wages paid is low relative to the public sector. With such a deficiency of demand and high levels of unemployment and spare capacity it doesn't make sense to argue that public sector activity is crowding out the private sector. Indeed, cutting public sector wages or restricting their growth relative to the private sector will limit the growth of demand further and so contribute to the problem of relative demand deficiency in such regions.

The insight in the proposal for regional pay lies in the possibility that in more normal times, when the regional economies of the UK are closer to full employment – more technically, closer to the non-accelerating inflationary rate of unemployment (NAIRU) or the 'natural' rate of unemployment – a lowering in public sector wages relative to the private sector could help boost the competitiveness of the local private sector. And this particularly in regions/nations where the public sector is relatively large. In such circumstances, the price effect on private sector competitiveness is likely to be more significant than the effect on regional aggregate demand of the incomes of public sector workers being a little lower.

But even if there was a positive effect on private sector competitiveness would lowering or slowing the rate of growth of public pay in so-called 'poorer' regions be warranted?

In simple theory, a market economy will pay workers according to the value of their marginal product. It is difficult to argue that the productivity of a nurse, or any other public sector worker, at the margin is lower in the North East than London. However, if prices and incomes are lower in the North East then the value in monetary terms placed on the work of the nurse might be lower. This might justify a lower wage than in London. But who is to determine the monetary value placed on the provision of a public good in a region such as the North east? Should it really be left to the UK Chancellor of the Exchequer?

An alternative view that chimes better with the ethos of regional variation and the rejection of national pay is that it should be the people in the North East themselves, who should decide. But to do that they would require a government that raises and spends taxes in the region according to regional preferences. In other words, it seems to me that the logic of regional variations in public sector pay is fiscal federalism with regional governments having responsibility for a range of taxes and the provision of public services including setting the pay rates of public workers.

Scotland has already gone a considerable way down this route and is likely to go further. While John Swinney, the Scottish Cabinet Secretary for Finance and Sustainable Growth has said that

the Scottish government will go absolutely nowhere near this proposal for the areas of pay policy that are under our control.

It does seem likely that the Scottish government will eventually pay its public sector workers according to how it values their services and according to what it can afford. It will not let London decide. The English regions might eventually follow Scotland's lead.

Jobs the public sector and fiscal austerity

So how's it going? How badly hit have jobs in the Scottish public sector been since fiscal austerity began? How has the Scottish private sector fared? The publication yesterday of the latest public sector employment data for both Scotland and the UK offers some help in answering these questions.

The issue is complicated for Scotland by the inclusion of the Scottish employment in HBOS and RBS in the public jobs data from the fourth quarter 2008, after the UK government took a majority stake in each. For ease of analysis I have put this employment back into the private sector. That done we get the following chart:

Public sector jobs (not FTEs but the head count) peaked in Scotland and Wales in 2008q4, in Northern Ireland in 2009q1 and in England in 2009q4. So, it is interesting that in Scotland, Wales and Northern Ireland, at least, public sector jobs were contracting even as the UK government was introducing a temporary fiscal stimulus. But when that stimulus turned to fiscal consolidation and austerity public sector job losses continued apace.

The chart suggests that Scottish government (and the reserved public sector in Scotland) was both quicker out of the blocks in introducing cuts and in the scale of the job losses. The reserved public sector - ex banks - contracted in Scotland at -10.7% from the peak at a faster rate than devolved public sector jobs. But the loss of Scottish government jobs was still large at -7.2% from the peak, compared to Northern Ireland and Wales.

So, what were the implications of all this for total employment and private sector employment in Scotland. The chart below offers some insights

Because the data are not seasonally adjusted I have smoothed the series using a four-quarter moving average. Public sector jobs in Scotland were falling through the recession and the decline accelerated as the recovery in the economy began. By 2001q4, the smoothed public sector series was -5.7% below its peak. But employment overall was -2.8% below peak. Clearly, it appears that there was no burst of private sector job creation as public sector jobs fell. This would appear to provide strong evidence against those who argued that cutting back the public sector would 'crowd-in' private sector employment. Conversely, at first sight it does not appear that the loss of public sector jobs would have made much difference to the path of the recession and recovery. The purple line is a hypothetical jobs figure with public sector jobs held at their peak throughout the subsequent period. On that basis, the recession would have been little different while the recovery would have been somewhat stronger. Total jobs in 2001q4 would have been -1.6% below the pre-recession peak compared to the actual -2.8%.

But wait! The latter calculation ignores any demand or multiplier effects on private sector employment of the reduced incomes and spending from the lower level of public jobs. If we use a public sector multiplier drawn from the Scottish input-output tables (Technical: Type II employment multiplier of 1.66) total employment would have been 0.7% below the pre-recession peak rather than 2.8%. Once that is done, the effect of fiscal austerity on overall employment is seen not to be trivial. However, the exercise should be viewed as illustrative. It might overstate the austerity effect because any 'crowding in' effects from lower wage costs and improved competitiveness in the private sector due to job shedding in the public sector have been ignored.

Nevertheless, that caveat apart, on the unsmoothed series total jobs have fallen by -90,000 since the pre-recession peak, private sector jobs have fallen by -48,800 and public sector jobs by -44,200 from their peak (The numbers don't added up to 90k because the peaks are different). In the absence of fiscal austerity, on a best case scenario, we might have been looking at a much lower job loss of around -16,000 instead of -90,000. This is one price we in Scotland appear to have paid for the UK government's policy of appeasing the bond markets and encouraging the confidence fairy.

Labour market weakens further

I suppose the most positive comment on the latest labour market data is that it could have been worse! In the quarter November to January 2012, Scottish employment fell by 11,000 (-0.4%). Unemployment, on the preferred ILO measure, rose by 6,000 (+2.5%). This was worse than the UK where employment rose slightly by 9,000 (+0.0%) and unemployment rose by 1% or 28,000.

The upshot of this is that the jobs gap between the UK and Scotland widened with employment in Scotland falling to -3.5% below the pre-recession peak. In the UK the increase in jobs meant that employment is now -1.4% below the pre-recession peak – see this chart:

Again it is worth noting that the jobs figures understate the weakness of the Scottish labour market because labour supply (working population) has been rising. This means that jobs to labour supply ratio is now much the same as it was at the trough of the recession – see chart:

This is a very difficult position to be in after nearly five years since the recession began.

Unemployment now stands at 234,000, which is close to the 237,000 unemployed at the worst point of the recession in May-July 2010. The Scottish unemployment rate has risen further to 8.7% compared to 8.4% in the UK. The unemployment numbers mask a much worse problem of young unemployed people, with 40% of total unemployment at the midpoint of July 2010-June 2011 comprising young people aged between 16 and 24. Around 18% of the 18-24 age group were unemployed at the July 2010-June 2011 midpoint. Worse, nearly 29% of the 16-17 age group declared themselves as looking for work, although this had fallen from just under 32% over the year. While not to diminish the problem, about a third of the young people in 16 – 24 age group are full-time students who are looking for work.

One comparative bright spot, in what is a fairly gloomy Scottish labour market picture, is the employment rate. In the latest figures the employment rate for 16-64 age groups was 70.8%, which is a little higher than the UK figure of 70.3%. The recent behaviour of the employment rate in Scotland and UK is shown here

This gives a slightly false picture since the data cover overlapping quarters. So, the rate rises in Scotland between Oct-Dec 2011 and Nov-Jan 2012 but it actually falls between the separate quarters Aug-Oct 2011 and Nov-Jan 2012. Moreover, the Scottish rate is clearly converging on the UK rate. In this context it is also worth noting that the unemployment rate as measured offers a more accurate indicator of the strength or weakness of the labour market than the employment rate as measured. This is because the unemployment measure embraces all those who are economically active, whereas the employment rate excludes economically active people older than 64. So, the reason why the employment rate is higher in Scotland than the UK even though its unemployment rate is higher is because employment in the post 64 age groups is relatively lower here. That is relative to both the 16-64 age group in Scotland and to the UK.