Scottish Economy Watch

Scotland and the Breakdown of the Euro

In our latest Economic Commentary we recognize that the situation in the Eurozone complicates the forecasting picture considerably.     We assume in our central forecast that for the medium term there is an essential "muddling through" process, with further support given first to peripheral country banking systems and then to their sovereigns if necessary. Through this process confidence remains low and growth is weak as austerity policies are not, or are insufficiently, relaxed. Moreover, complete steps to full fiscal union with Eurobonds and sizable fiscal transfers between countries, which would finally resolve the crisis, seem unlikely.

But there remains the risk of a Greek default and even exit from the Euro in the near term and the break-up of the Euro in the medium term. We have therefore considered these two outcomes as possible scenarios to assess their likely impact on the Scottish economy. We draw on this research produced by ING in December of last year.

The analysis is not a forecast but a 'what-if' impact study, with the impact on the Scottish economy assessed at the end of three years after each event occurs.

The impact of both a Greek default and euro exit and a complete break-up of the Euro would impact upon the Scottish economy through several different channels:

The figure suggests that the transmission mechanism embraces five main channels, through which GDP and jobs in the Scottish economy would be affected:    country GDP,     consumer confidence, business confidence, bank lending, foreign direct investment.

Changes in the GDP of Eurozone countries and other major economies in the wider global economy such as the US and the UK would affect Scottish GDP and jobs through a reduction in Scottish exports to such countries.

Reduced consumer confidence would bear directly on household consumption in Scotland.

Reduced business confidence would affect the willingness to export and invest.

Reductions in lending from Scottish and UK banks as they sought to rebuild their balance sheets would be likely to affect all three sources of demand: exports, consumption and investment.

A reduction in FDI flows from the Eurozone but also the US and elsewhere as their economies contract would clearly affect investment but also exports.

Finally, as GDP and jobs began to fall directly as a result of these Euro events multiplier effects would kick in leading to further secondary falls in domestic Scottish consumption and investment and hence GDP and jobs.

The results of this modelling exercise are presented first for GDP and then for jobs in the charts below:

It should again be stressed that these estimates are the result of a "what if" simulation with estimated impact after 3 years with all other things held equal. One countervailing force could be any monetary and fiscal policy responses introduced by the Bank of England and the UK Government.

If that caveat is kept in mind we can draw the following conclusions.

First, a Greek exit leads to a drop in GDP in Scotland of -1.2% and a loss of just under fifty thousand jobs. This is not trivial but small compared to the other events shown.

Secondly, the consequences of the breakup of the Euro would be a major economic event for Scotland even though we are not in the Euro. With an estimated drop in GDP of -5.3% and loss of -144,200 jobs the effect would be comparable in scale to the effects of the recent Great Recession and worse than our simulation estimate of the effect of fiscal consolidation. Such an event only a few years after two major exogenous shocks to the Scottish economy - Great Recession and Fiscal Consolidation - is something that we must hope can be avoided. Because if it does occur, the damage to the Scottish economy will be felt for many years to come.

Greek Tragedy

My short article in today's Scotsman on why the initial euphoria in the financial markets after the Greek election results was short-lived is here.

The fundamental problem is that Germany and the ECB are insisting on the wrong policies. Imposing harsh austerity on the Greeks will not deliver what the eurozone authorities want. There is little likelihood that present policies will resolve the Greek fiscal crisis and keep Greece in the euro. The same analysis also applies to Spain and Italy.

Financial market turbulence will continue unless and until there is significant forgiveness of Greek debt by the eurozone authorities. Significant steps towards the creation of a fiscal union are the only effective solutions to the financial problems besetting the eurozone. This would involve: greater fiscal transfers from Germany to the periphery, mutualisation of existing sovereign debt and reductions in the fiscal autonomy of member states.

And even then, if Greece manages to stay within the euro, a way has to be found to restore Greek, and other peripheral country, competitiveness relative to other eurozone states and Germany especially.

In the short to medium term, the only feasible way this can happen is for core eurozone and German wages and prices to rise relatively. Currently, this seems politically infeasible. Hence, a Greek exit from the euro and devaluation of the new Drachma remains likely. And the markets recognize this.

Tomorrow we, the Fraser of Allander Institute, publish our Economic Commentary. In addition, to our medium term forecast of output and jobs, we consider the implications of a Greek exit and eurozone break-up for the Scottish economy.

Small does matter

Paul Krugman rightly dismisses claims that the focus by advocates of austerity on the recent economic performance of small states such as Estonia and Latvia is irrelevant because they are too small to matter. Paul suggests that

every economy — even a small one — is potentially a "natural experiment" that teaches us more about how economies in general work. Beyond that, the Baltics now loom large in the imagination of austerity's defenders, particularly since Ireland keeps refusing to play along and be a success story.

However, care must be taken not to apply the evidence from small states to large states uncritically. Scale matters in the adjustment of countries to economic shocks. And this serves to invalidate many of the conclusions that the defenders of austerity would wish to draw for larger states.

Let me explain what I mean.

It is not unreasonable to expect that the variance of growth rates for small states should be higher than for large states. Small states are more open to trade and factor, especially investment, flows. They also tend to be more specialised. For both reasons they are more vulnerable to exogenous shocks. Although the evidence that the share of government consumption in GDP is usually high in small states might serve to dampen market volatility effects in such countries but make them more vulnerable to changes in the size of the state through, for example, fiscal consolidation. Nevertheless, evidence that small states, defined as a population of 2 million or less, do have a greater volatility of GDP is provided here, in this World Bank paper and here.

What this means is that it is probable that, other things equal, the recent Great Recession is likely to have produced a stronger downturn and a stronger upturn in small states GDP than that found in larger states. Just as the harder you throw a ball down the bigger the bounce, so GDP in smaller states might have been expected to bounce back more strongly. As Simon Wren Lewis states, by logical extension, if you

close the whole economy down for a year. The following year we could get fantastic growth as the economy starts up again.

The following chart offers some, all be it slight, supportive evidence

So, country size does matter.

It matters because the experience of small countries helps teach us how economies work. But it also matters because the experience of small countries is not a good guide to what happens in larger states. And the evidence on small country volatility provides a further reason to reject the arguments of the advocates of austerity who cite the economic performance of Latvia and Estonia and other small states in support of their claims.

Alternatives to Austerity

There is increasing evidence - see here and here - that austerity policies have been a failure in promoting an expansion of GDP as well as reducing high levels of government deficit and debt. These findings are buttressed by academic research - this blog by Simon Wren Lewis - that suggests that high government debt levels should be cut slowly.

The logic of this evidence is that a reversal of austerity policies, for a temporary period at least, should be introduced to encourage actual GDP to recover. Only, when GDP is expanding at trend or above and the economy is close to its NAIRU, or 'natural' rate of unemployment, should policies to reduce government's structural deficits and hence debt be introduced. Even then the speed of adjustment is still critical.

An objection to this approach reflects a fear that the financial markets would turn against the sovereign state that started to do this. The markets might refuse to buy its bonds or seek an ever greater risk premium. Hence, the fear that long-term bond yields would rise and the costs of financing government debt become punitive. But this view assumes that current low bond yields reflect financial market confidence in austerity policies. In fact, the evidence - see Jonathan Portes here - suggests that yields are low because the UK economy and the recovery is weak.

Moreover, financial markets also know that states that are monetary sovereigns i.e. have their own currency and a central bank able to print the currency, will not default on their debt unless by choice. This is one reason, at least, why the UK and the US are in a very different position from France and the periphery countries of the Eurozone.

Despite this, the concern about rising government debt levels has led many commentators to seek alternatives to debt financed fiscal expansion as the basis for their "Plan B".

Simon Wren Lewis makes clear here and here that in such a situation a balanced budget multiplier approach is an appropriate solution. Here a temporary increase in public spending is financed by an increase in taxes of equal amount. In simple economics, an increase in public spending of £1 raises demand by £1. Aggregate demand is raised because taxpayers draw some of their increased tax payments from savings as well as reduced consumption. The taxpayer pays more in taxes but this is offset by higher income. The balanced budget multiplier equals 1 and can be greater than one when interest rates are stuck at zero - as in current conjuncture. This is because any rise in expected inflation due to the demand stimulus will lower real interest rates and so stimulate activity further.

Indeed, as Simon further argues a stimulus effect can be secured without an increase in taxes as well as without further borrowing.

There is the option of tax and transfer switches, within a given tax burden, whereby taxes are cut/raised or transfers raised/cut for those groups with high/low marginal propensity to consume. Re-directing transfers in favour of the unemployed or those in receipt of benefits would be one possibility as I noted here. Simon also suggests ways in which a tax increase can be avoided: a debt financed stimulus can be reversed by lower public spending in the future and not by higher taxation.

A fiscal stimulus can also avoid higher taxes and increased borrowing by a monetary sovereign financing the temporary expansion through new money as Brad DeLong makes clear. I believe this would require legislation in the UK. But it seems to me that it would be a lot more effective than the current programme of quantitative easing (QE). The Bank of England could use sales of securities to lower the money supply once recovery was under way and the obstacle - to monetary policy - of the zero interest rate bound removed as rates rise.

At this point it seems appropriate to dismiss an "alternative" to austerity proposed by George Kerevan in the Scotsman on Friday. Kerevan notes that the Bank of England through its QE programme has built up large holdings of long-term UK government securities through secondary purchases from the private sector. He contends that

If the Treasury and the Bank of England agreed to cancel these bonds, the national debt would fall miraculously to a mere 41 per cent of GDP – very low by any standards. Plus government spending would be slashed by £18bn a year. That would cut this year's planned borrowing by 15 per cent. Alternatively, it could provide precisely the fiscal boost needed for growth – without adding to borrowing.

Unfortunately, it won't do anything of the sort. First, before QE, the interest payments of £18bn were being paid to the private sector, so redirecting them is not going to have that much expansionary impact unless it is along the lines of the tax/transfer switches noted above. Secondly, after QE, the £18bn interest or dividend payments are paid to the Asset Purchase Facility which is indemnified by the Treasury and is part of the public sector. The situation was clearly stated in the speech on QE by Charles' Bean, Deputy Governor of the Bank of England, in October 2009:

Any profits on the Asset Purchase Facility are passed to Her Majesty's Treasury, while any losses are also indemnified by the Exchequer. The accounts are therefore not consolidated with the Bank's own accounts, as the Bank has no economic interest in the fund.

.... gilts held in one part of the public sector, the Asset Purchase Facility, are just a liability of the rest of the public sector. In the accounts for the rest of the public sector, there must therefore be offsetting interest flows, as well as corresponding capital gains or losses,

.... whether the Treasury ends up with a profit or a loss from the Asset Purchase Facility represents only a small part of the picture. Gilt yields will be lower than they would otherwise have been during the period that they are held in the Asset Purchase Facility, so reducing the cost of financing a given budget deficit. This needs to be factored into any calculation of the implications for the public finances.

There are alternatives to austerity. There are alternatives to a debt financed stimulus and there are alternatives to tax financed stimuli. But there is no 'novel solution' to debt finance along the lines suggested by George Kerevan.

The Language of Growth

It is now being suggested that proponents of pro-growth policies are gaining the upper hand against the austerity advocates in Europe and elsewhere. But proponents of "growth" policies need to be careful. The problem we need to address is not a "growth" problem per se but one of a deficiency of aggregate demand. As I noted in this earlier post, in the context of the Scottish economy, the problem:

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. ..... 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. .... (M)any 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.

Advocates of "growth" policies in the present juncture need to watch their language.

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.

The benefits of true fiscal union (not the Euro kind)

In the financial crisis that came with the credit crunch and which led to the Great Recession, the two principal Scottish banks, the Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS), got into severe financial difficulties. The subsequent bailout by the UK government led to the government taking a stake overall of 82% in RBS and 43% of a new entity formed from the government encouraged merger of Lloyds bank and HBOS.

The scale of the assets of RBS and HBOS to Scottish GDP - which does not include oil - in 2008 is shown here and compared to Iceland and Ireland.

The story of Iceland and Ireland is well known. That of Scotland is less so because of Scotland's place in the wider UK monetary and fiscal union.

The subsequent GDP performance of Scotland compared to Ireland, Iceland and the UK is shown in the chart below.

Scotland broadly tracked the UK during the recession and in fact did a little better. Its performance compared to Iceland and Ireland, the former a completely independent country with its own currency and the latter a member of the Eurozone, speaks for itself. (Ireland does even worse on GNP but we don't have GNP data for Scotland, itself home to several multinationals.)

Is there any better example of the benefits of a true fiscal union?

S&P downgrade no comfort for Osborne

The S&P statement following yesterdays credit downgrade of France - downgraded from AAA to AA+ - and other Eurozone countries should offer no comfort to George Osborne, Germany and those who argue that it is fiscal austerity that is preserving the UK's triple A status. The statement from S&P indicates that it considers the focus on austerity in the periphery to be self-defeating and that it is as much about preserving demand and growth as about effective fiscal management and austerity. I quote at length from Reuter's publication of the statement

The agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone's financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone's core and the so-called "periphery." As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

The decision to downgrade the US on 5 August 2011 from AAA to AA+ had a quite different rationale, largely being about ineffective fiscal management and a failure to address long-term debt issues:

We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

However, as I noted in this post the rating agencies don't necessarily get their judgement of sovereign debt correct and the markets know it hence look at what has happened to the yield on US 10 year Treasuries since.

Yes, the yield has fallen from 2.56% to 1.86%! Other things matter as well as agency ratings.

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.

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.