Scottish Economy Watch

Scotland’s Recovery in the Short and Long Run

On November 12^th, we published our latest Fraser of Allander Institute Economic Commentary, - sponsored by PWC. On the same day, the Scottish Government published its quarterly accounts for the second quarter under the Scottish National Accounts Project (SNAP). The Commentary, therefore, could only analyse the drivers of Scotland's economic recovery up to and including the first quarter of this year, drawing on the previous SNAP publication in August.

The latest SNAP data allow us to extend the analysis to the second quarter and take account of revisions to GDP and its spending components in previous quarters. We include below a chart that updates Figure 18 on page 20 of the latest Commentary.

In the Commentary we concluded that elements of a balanced recovery were starting to fall into place, investment was picking up, reinforcing the continuing growth of household spending, while the balance between exports and imports – net trade – continued to be a drag on the economy.

The latest data reinforce that conclusion.

In the second quarter, nominal GDP grew by 1.3%. The main driver of growth was Gross Capital Formation or more loosely investment, contributing 1.95% points to growth, followed by household spending, contributing 0.68% points, and general government spending, contributing 0.28% points. Superficially, if imports had been balanced by exports nominal GDP growth would have been the sum of those three components, or 2.91%. Unfortunately, net trade (exports minus imports) was strongly negative, contributing -1.64% to growth.

Looking back over the previous 4 quarters it is quite clear from the chart that investment has played a stronger role in driving growth than the earlier data implied. Some of this clearly reflects construction spending on major projects such as the second Forth road crossing and it remains to be seen whether companies right across the economy are raising their investment spending. The positive contribution to growth of household spending is evident for 4 of the 5 quarters, although the contribution to growth is a little less on the revised data.

None of this diminishes our warning in the latest Commentary that the economy needs more investment and that government should play a key role by undertaking major infrastructure projects funded if necessary by debt rather than cuts in public spending in other areas. The weakness of Scotland's international trade position in fact reinforces the case for more investment both in the short and long run.

In the short-run there is still the need for strong investment growth to boost demand. Firstly, to offset the drag on the economy as the growth of imports continues to run ahead of the growth of exports, and secondly, to offset the expected slowdown in the growth of household demand as household debt rises and household incomes stagnate with little or no growth in real wages.

However, it is in the long run that the need for strong investment in the economy is even more pressing to improve competitiveness and overcome our weak international trade position. There is little doubt that Scotland's net trade position – excluding North Sea oil – is weak. From the latest SNAP data we can chart net trade as a percentage of GDP going back to 1998 and this is presented in the chart below:

Over the period the trade deficit has averaged just over 7% of GDP. As part of the UK union Scotland has received compensating fiscal flows with the fiscal deficit roughly mirroring the trade deficit, although a proper accounting balance would require the inclusion of net income from abroad to complete the balance of payments picture. An independent Scotland, in contrast, would have oil sales added to its trade account and these probably roughly balance the non-oil fiscal deficit.

The problem for Scotland in the future is that oil sales and oil tax revenues are declining. An independent Scotland would find it unsustainable to borrow to meet the loss of oil revenues and so would either have to cut public spending significantly or find new sources of tax revenue. Probably, the best solution would be to seek ways to raise the rate of growth of the economy generating tax revenues in this way. However, given the openness of the Scottish economy probably the only sustainable way to do this is to boost export performance significantly. Boosting domestic consumption and demand would almost certainly lead to imports being sucked in that would stall the growth process replicating the traditional UK experience of "stop-go".

The problem does not, however, go away if Scotland continues as part of the UK union. Under the new devolution arrangements that are coming into place while Scotland will not be assigned oil revenues, the decline of oil will have indirect effects on Scottish incomes, which will lower income tax yields here. And as I have argued above, higher and sustainable future income tax revenues are probably best achieved through increased growth that is export led. Moreover, from a political standpoint given that the Barnett formula remains in place for the residual portion of Scottish government revenues that are not raised locally, the pressure from Westminster to abolish Barnett and encourage greater Scottish fiscal autonomy seems likely to increase as oil revenues diminish.

So Scotland needs to boost its export performance. The Scottish Government's Programme for Scotland 2014-15 One Scotland recognizes the need for the Scottish economy to internationalise in Para 113:

Encouraging a greater international focus among Scottish businesses is a fundamental part of rebalancing of the Scottish economy, and delivering sustainable economic growth over the longer term. With this in mind, the Scottish Government has set an ambitious target for export growth, to increase the value of international non- oil and gas exports by 50 per cent by 2017.

This is an ambitious target. One might go further and suggest that without a systematic strategy to rebuild Scotland's non-oil export base there is little if any likelihood of policy raising the real value of exports in ten years never mind in two and a half years by 2017.

There is little in One Scotland to suggest that the Scottish Government has such as strategy; a subject that I shall return to in later posts.

Fraser of Allander Economic Commentary – 12 November 2014

 

Overview

• In the latest Economic Commentary we note that in the first half of the year the Scottish economy delivered strong economic growth, increased job creation and falling unemployment.

• However, there are signs that growth may be beginning to slow. Growth in the wider global economy and the UK economy appears also to have begun to slow recently.

• There are fears that the global economy faces a situation of secular stagnation, a permanent deficiency of demand, which can’t be overcome even with near-zero interest rates.

• The recent indicators of slowing demand both at home and abroad, falling real wages, rising levels of household debt, the prospect of more substantial UK fiscal austerity to come, and the deeper concerns about secular stagnation raise several questions.

• Questions that can be posed but cannot be definitively answered, such as whether the Scottish and UK economies are now poised for a period of slower but sustainable growth, or whether growth will slow and then slip back into recession? Are we at a turning point or are we on a knife-edge?

Output

• The latest Scottish GDP data for Q2 2014 show that Scottish GDP rose by 0.9% in the quarter, much the same as in the UK.

• Over the year to the fourth quarter - four quarters on the previous four quarters - Scottish GDP grew at 2.4%, a growth rate that is above trend.

• In the second quarter, GDP in Scotland was +1.1% above its pre-recession peak. Because of changes to accounting practices in the UK, which have yet to be introduced in Scotland, we do not have comparable UK data to Scotland in the second quarter. So, up to the first quarter of the year UK GDP was still -0.6% below its pre-recession peak compared to +0.2% in Scotland.

• The overall strength of the recovery has, nevertheless, been stronger in the UK than in Scotland because the depth of the recession was greater in the UK. By 2014q2 Scottish GDP had grown by 6.9% since the trough of the recession compared to 7.3% in the UK to the earlier quarter 2014q1. Jobs and Unemployment

• With the signs that the growth of productive activity may be slowing, we note also the strong performance of the Scottish labour market in recent months, with 52,000 jobs created over the year and unemployment on the ILO measure falling to 151,000 or 5.5%.

• However, despite the strong recent ‘headline’ recovery in the labour market, we are still some way from the conditions that maintained prior to the start of the Great Recession.

• Much of the recovery in jobs has been driven by the growth of part-time and self-employment.

• However, there is still slack in the Scottish labour market:

• full-time employment remains considerably below its pre-recession peak, although there has been some pick up in recent quarters;

• the total number of average weekly hours worked is at the latest data point -2.4% below the pre-recession peak;

• and, the employment to adult population ratio in June-August 2014 stood at -1.5% below the pre-recession peak, compared to -5.7% at the trough of the recession.

Drivers of the recovery

• Elements of a balanced recovery are falling into place.

• Household spending is continuing to make a positive contribution to growth but its underling determinants remain weak.

• The net (international) trade position has been consistently negative in the last three quarters.

• With a weakening global market the prospects that external demand will serve to sustain growth appear unlikely. Hence the prospects for sustained investment spending would appear to depend on the growth of domestic demand and household spending in particular.

• Investment is recovering, but only slowly prompting the International Monetary Fund (IMF) to urge Governments to undertake increased public infrastructure investment. Such investment the IMF argued raises output in both the short and long term, particularly during periods of economic slack and when investment efficiency is high.

• So, in countries with infrastructure needs, it considered the time was right for an infrastructure push as borrowing costs are low and demand is weak. Debt-financed projects could have large output effects without increasing the debt-to-GDP ratio, if clearly identified infrastructure needs are met through efficient investment.

• The IMF notes that the estimated quality of UK infrastructure overall has been improving in recent years but still remains below that of the major advanced countries - Germany, France, Japan and Canada.

• The UK Government appears to agree since at the time of writing it is unveiling plans for £15bn of new infrastructure projects this week to make it “easier than ever” to invest in the UK. Such public investment is to be welcomed.

• However, we contend that in the light of slowing growth, the risks of secular stagnation, the need to boost competitiveness, net trade and inward foreign investment, that there is strong case that Government, and the UK Government in particular, should borrow to invest more in infrastructure in and for Scotland.

• For example, more needs to be done to improve the infrastructure of road and rail, especially, between Scotland and the UK. Raising the borrowing levels available to the Scottish Government would also help to support and encourage its own plans for infrastructure investment within Scotland.

• An expanded programme of public investment would appear to be essential when the real volume of private investment continues to be below pre-recession peak levels in both Scotland and UK, even though private investment has picked up in recent quarters. And the investment should be funded by debt not by cutting current spending or other capital spending.

Forecasts

• We are now forecasting GDP growth in Scotland of 2.7% in 2014, 2.2% in 2015, and 2.1% in 2016.

• We have therefore revised up our forecast for 2014 from 2.5% to 2.7% due to the strong growth in the first half of the year. We have held our forecast for 2015 at 2.2% but have revised down our forecast for 2016 from 2.4% to 2.1% in the light of concerns about secular stagnation and a persistent weakness of aggregate demand.

• Production and manufacturing continue to be the major sectors exhibiting the fastest growth in 2014, 2015 and 2016.

• Our forecasts for employee job creation and unemployment are similar to June 2014, with some revisions. On the central forecast, we are now forecasting that net jobs will increase by 46,560 in 2014, 41,600 in 2015 and 48,900 in 2016.

• Our projection for unemployment on the ILO measure at the end of 2014 falls to 124,700 (5.3%). In 2015, unemployment is now forecast to fall slightly to 5.2% but to increase in terms of numbers to 141,019 as the workforce increases. Falling again, to 135,537 (5.0%) by the end of 2016.