Scottish Economy Watch

Austerity and the Recovery

Last night on Newsnight Scotland, Gordon Brewer subjected John Swinney and other non-Coalition politicians to some pretty tough questioning on the austerity and the UK recovery. As a presenter and interviewer it is normal to play 'devil's advocate' and challenge the beliefs, suppositions and arguments of interviewees, especially politicians. However, the ferocity of Brewer's onslaught seemed to me to go beyond what is required from an interviewer. Clearly, an interviewer must give due weight to and allow balance between the arguments of opposing sides. But he or she should, in my book, also pay heed to the truth - in this case the theory and evidence on the role of austerity in its effect on the level of GDP and its rate of growth.

Brewer made several assertions. The most important of which were:

1. Economic recovery justifies the austerity policy of the Coalition Government.

2. The scale of the UK output loss meant that other countries would recover faster than UK, so the fact that UK GDP currently remains about -2.5% below its pre-recession peak cannot be used as a criticism of the policy of austerity.

3. The austerity policy was necessary to address the UK's credibility with markets in the face of rising UK Government debt.

4. The OBR believes that "it will eventually become a sustainable recovery."

None of these assertions is unambiguously correct.

The first assertion is simple to dismiss. Economic theory tells us that a fiscal consolidation will lower the level of GDP and the rate of growth. But it will be temporary. Eventually the resources made unemployed by the austerity will move into other uses as market prices adjust, growth will pick up and the level of GDP rise. For non-technical discussions of this see Jonathan Portes, Director of the National Economic Institute for Social and Economic Research (NIESR), and Simon Wren Lewis, of Oxford University. However, some of the loss of GDP and unemployment could be permanent if there are hysteresis effects for which there is a real possibility - see this paper by Larry Summers and Brad Delong. These effects are difficult to model and the OBR makes no allowance for them at all.

So, even with austerity an economy will recover and when it recovers it may exhibit quite strong growth. None of which is to demonstrate that austerity has been a wise policy or "a good thing".

To underline the point that austerity has had a negative effect on the level of GDP in the UK here is the OBR's own graph which shows the effect of the different phases of the UK's fiscal consolidation.

Chart 2.26: Implied impacts of discretionary fiscal policy on the level of GDP

The assertion that the scale of output loss implies that the UK would have had a slower recovery than others is simply wrong. Indeed, you can argue the opposite: a big drop in output should be associated with a big bounce back in growth analogous to the bouncing ball phenomenon: the harder you throw the bigger the bounce.

Bank of England economists, who clearly have no political axe to grind show the UK recovery from the recent recession to be weaker than almost any comparator - see the chart below

Figure 1.  Evolution of GDP around recessions (a) and banking crises

Sources: OECD, Reinhart, C.M and Rogoff, K.S (2008), Thomson Reuters Datastream and Bank calculations.

(a) Defined as at least two consecutive quarters of falling output.
(b) Where data are available, covers the G20 advanced economies over the period from 1960 to 2006.
(c) Spain (1977), Norway (1987) Finland (1991), Sweden (1991) and Japan (1992), as defined in Reinhart, C.M and Rogoff, K.S (2008) 'This time is different. Eight centuries of financial folly'.
(d) Zero denotes the pre-recession peak in GDP, or the peak in GDP during the year of the banking crisis, as listed in footnote (c).

As I have said in earlier posts the reason for the UK's weaker recovery is weak UK export performance and fiscal consolidation - see this research from Fulcrum here.

The third assertion, has been well addressed by Paul Krugman in his references to the "confidence fairy". There is just no evidence that a country with its own currency and ability to print money will be at risk of default as debt rises. UK 10-year bond yields were low before the Coalition came to power and have stayed low. They rise when economic growth occurs as the attractiveness of equities increases relative to government bonds. This is happening now. But would the Chancellor say now that this is due to a loss of confidence in his stewardship?

Finally, the OBR did not say in its latest Economic and Fiscal Outlook that " it will eventually become a sustainable recovery." In its view the recovery is being driven by household spending fuelled by falling savings not rising income and housing investment. Real incomes of households need to rise and that will only happen according to the OBR if productivity growth improves. Which begs the question are current UK Government policies towards investment and skill formation appropriate to the task?

All of this is a lot more nuanced and complicated than was allowed to be the case on Newsnight Scotland last night.

 

Autumn Statement: smoke and mirrors

Chancellor George Osborne will stand up in the House of Commons today to make an Autumn Statement on the government's finances and the prospects for the economy.

The statement will be full of references to growth. The Chancellor's likely failure to meet his deficit and debt targets will be attributed to the weak underlying growth of the UK economy after the financial crisis. More austerity will be needed to meet his targets.

There will be no mention in his statement that his own policy has played a considerable part in the current weakness of the British economy.

It is true that the Chancellor can point to the views of the OBR, IFS, and others who believe that the supply capacity of the UK economy has been damaged by the financial crisis and Great Recession. In technical terms their view is that productivity growth is so slow and the recovery so weak because the crisis has led to productive capacity being lost forever in particular sectors and activities. The 'output gap' between supply and demand is small. Hence, to get more growth more capacity is needed. And that requires investment by both public and private sectors.

There is no doubt that there is some truth in this story. Labour productivity is clearly weak. But there is little other evidence that the economy is supply constrained.

A supply constrained economy would see wages and other factor prices rising quickly generally and specifically in those sectors that are most supply constrained.

There is no evidence of this.

Although advocates of the supply-constrained view suggest that wages and prices would be falling if the output gap was large. But this surely flies in the face of all the evidence that wages and prices are sticky downwards in most modern economies.

Moreover, with interest rates close to zero, at the zero lower bound, the economy is in a liquidity trap with nominal rates unable to fall far enough to equate the demand and supply of money, and savings and investment. The result is a deficiency of aggregate demand unless and until demand increases directly. And what we do see is clear evidence of a lack of demand. Household spending is weak, investment is weak, net export demand is weak and the government is engaging in an unprecedented programme of fiscal consolidation.

So what can we conclude?

First, estimates of the output gap are just that: estimates, difficult to realise and subject to error. Secondly, suppose, as Simon Wren Lewis argues that supply is following demand. Raise demand and supply increases as discouraged workers re-enter the labour market, as firms raise production from their existing workforce by staff beginning again to operate at more normal levels of input, and as idle plant and machinery - from bankrupt and closed firms as well as currently operating firms - is brought on stream. Thirdly, if supply also follows demand and then after a time is lost forever - what economists call hysteresis effects - then the costs of not seeking to stimulate demand are high.

Against this background Wren Lewis argues that

policy should lean towards being optimistic about supply, even if we are somewhat sceptical that it is really following demand - because the costs of self-fulfilling output gap pessimism could be so high.

But we won't get that in the Autumn Statement today.

Any spending changes the Chancellor introduces are likely to be at best fiscally neutral and at worst fiscally tightening. That is he will either seek to keep to his budget deficit targets or may tighten them.

Spending more on capital investment projects, schools and hospitals, will, if it comes at the cost of reduced spending elsewhere in departmental budget, have little if any stimulative effect on aggregate demand. Indeed, if the deficit target tightens it may have a depressive effect on the economy.

One way that the changes might stimulate demand is if the fiscal multipliers associated with the spending rises are higher than those associated with the areas where spending is being cut. We don't have relevant UK data. But I have my doubts. Increased spending on so-called 'shovel-ready' capital projects will boost supply in the medium to longer term. But will it boost demand in the short term if it is funded by civil service redundancies in other government departments?

It may do since the fiscal multiplier on infrastructure and particularly capital spending on roads and highways is, from US research, quite high. But it won't be that much higher than the negative spending effect of civil service job cuts and other spending cutbacks.

Moreover, even if the British economy is severely supply constrained this doesn't excuse the Chancellor's policy of extreme fiscal consolidation. There is clear evidence that his policy has taken demand out of the economy. Are the Chancellor and his supporters really seeking to argue that without fiscal consolidation there would have been excess demand and runaway inflation?

The evidence is that his policy has weakened the British and Scottish economies.

In what one might call a 'moderate' or middle-of-the-road assessment, Gavyn Davies and Juan Antolin-Diaz in a Fulcrum Research Paper estimate that "fiscal austerity" since 2010 has accounted for almost half of the shortfall in UK GDP relative to the US since 2007 - see chart below. The other main contender is the UK's weak export performance. And this latter has particular resonance for Scotland.

Davies and Antolin-Diaz assume a fiscal multiplier 0.5 in 2008-2009 and 0.7 in 2010-2012. This is below the range of 0.9 to 1.7 suggested by the IMF in its recent Economic Outlook and below the figure of 2 suggested in the recent US research noted earlier. On this basis the impact of fiscal austerity will be even greater than Davies and Antolin-Diaz's estimates.

But don't expect to see an acknowledgment of any of this amidst the smoke and mirrors of today's Autumn Statement.

Even Nobel prize-winners get it wrong

Yesterday, the eminent Nobel laureate in economics Professor Sir James 
Mirrlees and the ex MPC member and noted labour economist Professor David Blanchflower CBE, joined together with Professors Andrew Hughes Hallet and Drew Scott to publish a letter in the Scotsman.

The letter argued for the UK government to undertake a fiscal stimulus focused on increased capital investment to boost the flagging UK and Scottish economies.

I totally agree with them. As I have noted in numerous posts on this site it is demand deficiency, made worse by the Coalition government's fiscal consolidation that accounts for the present weakness of the British economy.

However, the letter seeks to justify the authors' stance with the following

The Scottish Government has consistently argued for what First Minister Alex Salmond calls a UK Government "Plan Mac-B" based on the Scottish experience during the last recession from 2008. That downturn was shorter and shallower in Scotland than the UK as a whole.

Mr Salmond argues that his devolved administration's decision to bring forward capital investment spending on infrastructure construction contributed significantly to this relative performance. We agree.

The key facts cited in this statement are open to dispute.

First, there is some truth in the view that the "downturn was shorter and shallower in Scotland than the UK as a whole". But readers can make their own judgement by looking at the following chart.

The revised data to the first quarter 2012 show that the fall in GVA/GDP in the recession was greater in the UK, -6.3%, than in Scotland, -5.8%, but not by much. And the revised data show that the duration of recession was, at five quarters, the same in both Scotland and the UK.

Secondly, there is little evidence to support the contention that the SNP government decision to bring forward spending on infrastructure construction had any impact on the scale and duration of Scotland's recession.

The obvious point is that the construction industry contracted by slightly more in Scotland than in the UK as this chart shows

Yes, the bounce back was slightly stronger in Scotland but it soon petered out and now the sector languishes in much the same position as it was at the trough of the recession. Unlike UK construction, which while still in a dire position is about 12 percent below its pre-recession peak.

Both Scottish manufacturing and services lost less output to the trough of the recession than the UK, and that is the reason for the shallower recession here not the performance of construction.

Manufacturing probably did better because of the performance of the whisky industry. And services probably did better because of that age-old reason: a bigger public sector in Scotland.

So government did have a role to play in the shallower Scottish recession. But not because of Mr Salmond's policies.

I have the greatest respect for Professors Mirrlees and Blanchflower but they shouldn't be seduced by the siren voices of two Scottish economists of known nationalist sympathies.

It's the demand, stupid!

It is beginning to dawn on the Scottish and UK business community that the UK coalition government's austerity programme is not going to work. It is not going to work to get a recovery going to anywhere close to pre-recession trends. Nor is it likely to lead to a marked improvement in government borrowing and debt levels as yesterday's figures showed.

Business organisations want the government to do something. But they are caught in the trap of their earlier support for the austerity programme. So, some argue for austerity i.e. government spending cuts, but want more help for business, to boost confidence and 'supply-side' measures - see for example here. The Institute of Directors (IOD) particularly supports austerity, yet argues for tax cuts - for business of course - and other steps to reduce the costs of doing business such as less business regulation.

The IOD yesterday published a survey of its members on the prospects for growth in the British economy. Quite reasonably its members were not very sanguine. Its members also believed that the UK government's supply-side reform measures - including on taxation, regulation, education and infrastructure - were ineffective. But the IOD's Chief Economist Graeme Leach tried to link the flat lining economy and slow recovery to the weak pace of government supply-side reform:

Business is battening down the hatches in the expectation that the recession will continue for the rest of the year. .... Low confidence leads to delayed decisions, and delayed decisions further undermine economic confidence – it's a vicious cycle. At the same time, the Government's reform agenda is pointing in broadly the right direction, but the overwhelming opinion of our members is that they are doing too little, too slowly. If the Coalition wants to break this cycle of low economic confidence, then they need to take some bold steps that will make a real difference to the cost and complexity of doing business in the UK.

All of this is, quite frankly, nonsense. As is the government's view that our double-dip recession and lack of recovery from the first recession is due to the problems in the eurozone.

As I noted in this post, the current problem confronting the Scottish and rest of UK economies is not a lack of capacity, or inefficient use of supply, that might be remedied by "supply-side" measures. There is plenty of capacity, notwithstanding the possible large drop in productivity since the Great Recession. With unemployment at 8% and many shops, offices, factories, and machines idle, there is plenty of capacity.

What is required is to raise the utilisation of that capacity now and, yes, appropriate supply-side measures may help to raise the growth of supply potential for the future. But for now we need more demand in the economy to get capacity utilisation up.

Household spending accounts for around 60% of Scottish GVA or 40% of final demand. It is the principal component of demand. The following chart of Scottish household spending is drawn from recent data published by the Scottish government as part of its Scottish National Accounts Project (SNAP). The data run from the first quarter of 1998 to the first quarter of this year. The SNAP data are presented in current prices, so I have cast the data into real terms using a deflator for UK consumption spending from the ONS. The use of a UK deflator could distort the Scottish figures but I doubt if there would be much difference in the degree of price change in final consumption goods consumed north and south of the border. Readers should, nevertheless, bear this in mind.

What is clear from the figure is that Scottish household spending has been following a path which, to say the least, is significantly weaker than before the Great Recession. The trend since the 'recovery' began in the third quarter of 2009 can best be described as 'flat', with spending still nearly 7% below its pre-recession peak in the fourth quarter of 2007 and almost identical to the peak to trough drop in spending during the downturn.

Is it realistic to account for this sustained weakness of consumer demand as due to too high business taxation, too much business regulation and 'red tape'? Of course not.

Is it reasonable to put this stagnation in consumer demand down to the problems in the eurozone? Hardly.

The problem is that households took on too much debt before the recession and they are still trying to restore their finances by saving more, paying off debt and spending less. The other private components of aggregate demand, exports and investment remain weak again largely due the hangover left by the Great Recession.

In these circumstances, the only countervailing force is net government spending, whether via tax reductions or spending increases.

Instead, we have a government whose policy is to do the opposite. A policy that is thwarting incipient recovery and hangs like a millstone around the neck of the UK's medium term economic prospects.

Anti-Austerity Policy: Independence or Devolution?

In this post I argued that

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. .... 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.

However, I wasn't able to offer any numbers. I suggested that

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.

Full and detailed research is still required but I am now able to offer some 'ready-reckoner' type estimates that give some idea of the magnitudes involved. They should be viewed as illustrative and not definitive.

The first point to note is that small open economies such as Scotland, whether politically independent or not, tend to have smaller fiscal and other multipliers than larger states. This is because when the propensity to import from a pound/dollar/euro of extra spending is high much of that spending will 'leak out' of the economy. Ray Barrell, Dawn Holland, and Ian Hurst have recently produced this paper for the OECD, which looks at fiscal consolidation in 18 OECD countries. Using the National Institute Global Econometric Model (NiGEM) they provide estimates of first-year multipliers for different types of fiscal intervention. These multipliers are shown to be larger the bigger the country and the lower the degree of import penetration.

The chart below reproduces their data for the relationship between temporary spending reduction multipliers and import penetration:

Using the estimates provided by Barrell et al we can estimate a spending multiplier for Scotland using a measure of import penetration drawn from the 2007 Scottish Input-Output tables - see here. Scotland's share of imports in GDP/GVA is 0.66, which compares with 0.70 for the Netherlands, 0.72 for Ireland, and 0.80 for Belgium. This gives a spending multiplier of -0.17 for Scotland using the average relationship derived from Barrell et al's work. But this value could be too low if Ireland is a close comparator so we also use the value of Ireland's multiplier of -0.33 in the exercise below.

We now assume that the UK government introduces a fiscal spending consolidation equal to 1% of GDP which can be either temporary or permanent. The impact on Scottish GDP is estimated in Table 1 for different constitutional states:

Under the status quo it is assumed that the UK fiscal multipliers apply, from Barrell et al. GDP falls by a temporary 0.74 percent for a 1 percent of GDP reduction in UK public spending. The permanent fall in GDP is less because the NiGEM model allows for UK monetary policy affects as long-term interest rates fall boosting demand and production.

But under independence Scotland will have its own tax and spend regime and we assume that direct fiscal consolidation applies only in the rest of UK.

However, Scotland is not unaffected.

Around two thirds of Scottish exports go to the rest of UK, representing a 34 percent share of Scottish GDP. So, even under independence with no fiscal austerity from the Scottish Government GDP falls - by 0.25 percent. The permanent impact is lower too under Scottish independence, because we assume that an independent Scotland remains in sterling and therefore interest rates in Scotland move in line with the UK.

What about the impact under devolution?

Under Devo-Max, or full-fiscal autonomy, the GDP effect is assumed to be the same as under independence.

But under Devo-Plus, where we assume the Scottish Government has responsibility for tax and spend equal to 50 percent of its revenues and expenditures, the fall in GDP is greater than under independence but less than the status quo for both temporary and permanent fiscal consolidations.

If a Scottish Government seeks to defend against the fiscal austerity practised by the UK Government, what would be a fiscally neutralising response?

Table 2 illustrates.

Table 2 shows what a Scottish Government would be required to do if it wished to neutralise the impact of a 1 percent UK fiscal austerity on its GDP. Under Independence and Devo Max it would need to raise spending by 0.77 percent to 1.43 percent of GDP. The lower figure is based on Ireland fiscal multiplier of 0.33, the larger figure is based on the 0.17 multiplier derived from feeding Scotland's import share into the relationship estimated from Barrell et al's paper.

What is interesting about these estimates is that size of the neutralising spending increase required under Devo Plus: from 1.5 per cent to nearly 3 percent of GDP. The present UK Government's fiscal consolidation programme is seeking effectively to remove 6 per cent from GDP. So, this would be exceptionally difficult to fully neutralise, if not impractical, under Devo Plus. It would also be a tall order under Independence or Devo Max.

But let no one rush off and seek to argue that this analysis supports the view that Independence is the only constitutional state that would allow Scotland to defend against UK fiscal austerity.

In order to raise public spending to defend against UK fiscal austerity, the Scottish Government would need to increase its budget deficit. To do so it would have to borrow - sell bonds. It is likely that an independent Scottish Government would face long-term borrowing rates that are higher than the UK - see my post here and here. It would also, if using sterling, have to operate under fiscal rules on deficit to GDP and debt to GDP set by the Bank of England. Two issues follow.

First, if deficit and debt levels are already high then an independent Scottish Government's room for manoeuvre to offset UK Government austerity, even partially, may be limited, if not precluded all together by financial market constraints.

Secondly, it is a moot point whether an independent Scotland would be faced with a higher long-term borrowing rate than a devolved Scottish Government borrowing with UK Treasury backing.

In sum, a Scottish Government of whatever constitutional ilk would be severely constrained in defending against a large UK fiscal austerity programme. This is because the Scottish economy is highly integrated through trade and labour market links such as migration with the rest of UK. Political independence would not change this much.

The Krugman-Layard Manifesto

I support the Krugman-Layard Manifesto and urge others to do so.

Krugman and Layard in today's Financial Times suggest that

As a result of their mistaken ideas, many western policy makers are inflicting massive suffering on their peoples. But the ideas they espouse about how to handle recessions were rejected by nearly all economists after the disasters of the 1930s. It is tragic that in recent years the old ideas have again taken root.

With the crisis well into its fourth year, Scottish GDP remains 4 percent below its pre-recession peak, employment is 3 percent below, the ratio of employment to working population is nearly 6 per cent below, and unemployment at 8.2 percent is significantly above the pre-recession peak of 3.9 per cent and the 5 to 6 percent range that economists believe is associated with stable inflation.

Fiscal austerity isn't working. The evidence is overwhelmingly against it producing an expansionary effect on GDP. It is making the crisis worse.

Sign the manifesto here.

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.

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.