Scottish Economy Watch: Macro-policy

Macro-policy

26 March 2012

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.

Posted at 01:27 PM in Independence, Macro-policy | Permalink | Comments (1)

19 February 2012

Scotland needs an OBR plus

Bill Howat's call for a Scottish public spending watchdog to be set up along the lines of the Office for Budget Responsibility (OBR) in the UK, is worthy of serious consideration. But we should go further. A case can be made both for a stronger internal challenge function within the Scottish government and an independent external body such as the OBR to monitor government fiscal plans.

Fiscal Councils are becoming popular in several sovereign states as a complement to, and even a substitute for, fiscal rules. The UK macro-economist Simon Wren Lewis has been an advocate of fiscal councils for some time and has written extensively about the concept individually and with collaborators see here and here. As Simon says on his fiscal council's web page

The term Fiscal Council is generally used to describe an institution, funded by but independent of government, which provides public advice on fiscal issues ..... these same institutions may or may not also provide detailed microeconomic costing of the budgetary impact of particular projects or proposals (as is the case of the CBO in the US, for example.)

Wren Lewis and Calmfors point out that the limited statistical evidence on their impact is mixed. But they highlight several theoretical reasons why fiscal councils can be a valuable aid to prudent fiscal management. First, a council can help correct the deficiencies of information that produce a 'deficit bias' in government fiscal behaviour. Better forecasts of the public accounts and a reminder to the public of the need for government debt to be backed by expected future cash flows i.e. future taxation (technically: government's inter-temporal budget constraint). Moreover, a council can help provide the co-ordination to overcome 'common pool' problems where, for example, many spending ministers may be involved in setting budgets, but who may fail to internalise the overall costs of higher spending and debt.

The need for such an institutional innovation would appear to be high in Scotland given where we are currently in the devolution process and in view of what may lie ahead if there is a 'yes' vote to independence in the forthcoming referendum.

The current settlement provides a form of hard budget constraint through the changes in the block grant assigned to Scotland via the Barnet Formula. However, the availability of borrowing powers in the present Scotland Bill and the high probability of something close to full fiscal autonomy post independence referendum, increases the risk of both 'deficit bias' and 'common pool' problems. Moreover, the 'deficit bias' issue is likely to be worsened by a situation where a future Scottish government is dependent on volatile oil revenues for around 12 percent of its revenues.

The UK Treasury and the Bank of England are likely to insist on Scotland adhering to a set of fiscal rules if Scotland remains within the union but secures a high degree of fiscal autonomy. The Scottish government would also have to observe similar rules if it became independent but chose sterling as its currency - see this earlier post. A Scottish Fiscal council monitoring inter alia adherence to the fiscal rules would smooth relations with the Bank of England and the wider financial markets.

So, we should applaud Bill Howat's call and urge its further consideration. But in my opinion we need not simply a forecasting and monitoring body like the OBR but an organisation like the US Congressional Budget Office (CBO) or the Central Planning Bureau in the Netherlands. These two bodies also undertake detailed costing and appraisal of alternative policies. That is something that the OBR cannot do.

Finally, the discussion of the role of fiscal councils tends to assume that within government there is a separate finance ministry that provides an internal challenge function to spending departments. The UK Treasury offers a good example. In Scotland, in contrast, we do not have a finance department equivalent to the UK Treasury. It is true to say that the status and significance of the finance function has increased under John Swinney and the SNP government. Yet, the Finance and Sustainable Growth department is both a spending department (transport, local government, Scottish Enterprise etc) as well as performing a treasury function. The two roles do not seem compatible. And while that continues, the case for a Scottish Fiscal Council would appear to be even stronger.

Posted at 11:42 PM in Independence, Macro-policy | Permalink | Comments (1)

10 February 2012

Monetary and fiscal stimulus

A Scotsman leader expresses concern about the Bank of England's announcement yesterday of a further £50 billion programme of quantitative easing, and notes that all other stimulus options are exhausted.

This is not correct. All stimulus options have not been exhausted.

The latest National Institute Economic Review from the National Institute for Economic and Social Research (NIESR) suggests that in the current conjuncture there is still scope for a further fiscal stimulus. Jonathan Portes, NIESR's Director writes

The UK economy currently suffers from deficient demand; the current stance of fiscal policy is contributing to this deficiency. A temporary easing of fiscal policy in the near term would boost the economy. The credible commitment to a sustainable fiscal policy over the longer term provides the Government with the flexibility to provide a clearly defined and temporary boost to near-term demand. An increase in government investment would not have a significant impact either on long-run sustainability or – given the way they are defined – the likelihood of the Government meeting its fiscal targets.

In any event, there are concerns that quantitative easing has only limited impact on the growth of real and nominal GDP. Bank of England estimates suggest that the initial £200 billion of quantitative easing may have only raised GDP by a once and for all 1.5%. A respected commentator such as Chris Dillow suggests that this is likely to be an overestimate. I agree with him. This is what one would expect anyway if interest rates are at the lower bound and we are technically in a liquidity trap. To simplify, sellers of bonds to the Bank may simply be sitting on the cash, with banks reluctant to lend. The ripple effect of re-purchases of other financial assets pushing up their prices and the downward effect on sterling is likely to have been relatively weak. It is clear that while base (narrow) money has expanded due to QE, broad money (M4) has not expanded by much, confirming the absence of much greater lending and the creation of bank deposits on the back of QE. See this chart

In these circumstances, when the transmission mechanism of QE through to the real economy is weak and there are concerns about the further borrowing required to fund a further fiscal stimulus, the solution is to combine the two. That is finance the further fiscal stimulus by printing money.

The leading macro-economist Brad DeLong of the University of California, Berkeley, notes

By contrast, the alternative expansionary policy is for the government to print money and spend it buying useful things. Then:

The buying of useful things raises spending.
Financing it by printing money rather than issuing bonds means no increase in interest rates to crowd out private spending.
Financing it by printing money rather than promising to levy future taxes means no increase in the present value of future tax liability to crowd out private spending.
Financing it by printing money means no worries about any increase in fears of some future government default........

To try to target nominal GDP using either only monetary policy or only fiscal policy seems hazardous. To coordinate--monetary and fiscal expansion, money printing-financed purchase of useful things--seems to be the winner.

Posted at 11:28 AM in Macro-policy, UK economy | Permalink | Comments (0)

04 February 2012

Currency: emerging myths

As the debate continues about Scotland's choice of currency post independence I notice a disturbing tendency to assume that the issue is one that can be resolved politically. Get a currency deal with the UK Treasury and everything will be ok; just another one of the agreements that would have to be made about splitting institutions following independence.

This is fundamentally misconceived.

The adoption of a currency post-independence is not simply a process issue that once negotiated can be set aside. The currency choice sets a critical parameter for the conduct of Scotland's economic affairs after independence. As I noted here

This means that Scotland would not be equal to rUK. The BOE would be the rUK's central bank performing some necessary financial and monetary stability functions for the sterling union. There would be no Scottish central bank. There would be a common nominal interest rate across the sterling union. The BOE would act as "lender of last resort" to all banks in the monetary union, including Scottish banks, but would do so at 'penal' or above market rates. It would also require Scottish banks to satisfy UK financial stability rules, implementing the proposals of the Vickers' Commission and so on. The BOE would need to do this as part of its objective of ensuring financial stability in both rUK and the wider sterling union. The Scottish government would be issuing its own bonds but in sterling. It would effectively be borrowing in a foreign currency and would have no ability to print money. Accordingly, the markets are likely to demand a higher yield premium on Scottish 10 year and 30 year bonds than rUK Treasuries and present UK Treasuries.

Further, on the fiscal position of an independent Scotland that adopted sterling I noted

the BOE and the rUK government would require the Scottish government to observe an agreed set of fiscal rules which would likely cover limits on the scale of borrowing, the size of the primary budget deficit in relation to Scottish GDP and the level of Scottish government debt to GDP. The demands from the rUK government could be quite restrictive. Accordingly, the Scottish government might not observe these rules and the financial markets would be uncertain what would happen if Scotland, being unable to print or change the value of its own currency, defaulted on its debt. We have seen the difficulties this has caused with the financial markets in their uncertainty about whether the ECB will support member states by buying their bonds. Again the result would be Scotland's sterling denominated bonds trading at a premium to present UK Treasuries.

This position is almost identical to that outlined by the National Institute for Economic and Social Research yesterday. The requirement that Scotland adopt certain fiscal rules is the 'price' that Scotland would have to pay for the BOE continuing to be lender of last resort to Scottish banks and enjoying the benefits of stable international currency. The BOE and the rUK government would desire Scotland to adhere to the fiscal restrictions because there would be a risk that Scotland might experience a deteriorating balance of payments and fiscal position with an increasing risk of default on its bonds. All of that could de-stabilise sterling.

The view that the BOE can be viewed as separate from the rUK government in matters such as this is risible. The ultimate guarantor of the BOE is the UK tax payer. And, in the event of Scottish independence it will be the rUK tax payer alone.

It is further argued by some that the problems of the Eurozone were caused by fiscal irresponsibility and that since the Scottish government will prudently manage its finances none of the above is really relevant. But this is a false premise. The problems within the Eurozone are essentially due to the growth of current account imbalances with rising deficits in the periphery and rising surpluses in the core - essentially Germany - see this earlier post.

So, it is possible to envisage a situation in which a post-independence Scotland might attract significant capital inflows that flow largely into property, non productive investments and domestic consumption. The process would tend to fuel rising domestic prices i.e. inflation, in Scotland if the capital flow did not raise productivity. Hence there would be a rising real exchange rate, deteriorating competitiveness and a worsening trade position. As jobs are lost and companies close, the Scottish fiscal position would deteriorate and this would be worse if there was a sudden stop in the capital flow as happened in the Eurozone. The point here is that a Scottish government with prudent fiscal intentions might still end up in dire fiscal position which would make their bond yields rise and which could pose a threat to the stability of sterling.

All of which leaves me with one final myth: the view that Scotland wouldn't be able to run an independent fiscal policy if there was a requirement by the BOE and the rUK that Scotland operate under a set of fiscal rules. Indeed, within a monetary union a sub-sovereign state only has fiscal policy with which to manage aggregate demand in its economy - see the respected macroeconomist Simon Wren Lewis on this. In the above example a prudent Scottish government would have begun to tighten fiscal policy as domestic prices started to rise. Something which if it had happened in the periphery of the Eurozone before the credit crunch would have mitigated first the balance of payments problem then the fiscal problems that they are currently confronting; as would fiscal expansion in Germany now.

An independent Scotland would need to use fiscal policy in a sterling monetary union as the only instrument directly available to it to manage aggregate demand. It would, however, have to do so within a broad fiscal framework set by the BOE and the rUK government.

Posted at 11:42 AM in Independence, Macro-policy | Permalink | Comments (2)

18 January 2012

Fiscal austerity, expenditure and UK GDP growth

I have been thinking further about the prospects in 2012 and beyond for both Scotland and the rest of the UK economies. The latest outturn and survey data suggest that growth weakened further in the final quarter of last year. Consumer price inflation (CPI) is now clearly reducing as predicted. Today's CPI figures for the year to December indicate a rate of 4.2%, a sharp fall on the 4.8% increase to November. Christmas discounting in clothing stores and supermarkets plus the softening of fuel prices played a big role. But whether directly or indirectly, the slowing of inflation reflects a weakening of demand in the domestic and global economies.

The November 2011 forecast from the Office of Budget Responsibility (OBR) predicts weak growth of 0.9% this year followed by a bounce back to 2.1% in 2013, almost to trend. Forecast growth strengthens thereafter to 2.7% in 2014 and 3% in both 2015 and 2016.

What is more interesting than the aggregate forecast is the contribution to GDP change of the key expenditure components - see first chart.

So which components contribute the most to recent growth and to forecast growth?

The bounce in inventories in 2010 was a temporary influence on growth. Further adjustments might be expected if companies' expectations of demand are not met. But the OBR is not expecting much impact on forecast growth.

Between 2010 and 2011 there are two key narratives.

First, there was a switch from domestic demand to external demand as the main driver of growth. Private consumption went from 0.7% growth to a contraction by the same percentage. Business investment similarly went from 0.1% growth to a fall of -0.1%.

Secondly, government consumption and investment expenditures contributed positively to growth in both years by 0.4% points and 0.3% respectively. "Hang on!" I hear you say. "I thought the economy was suffering from the effects of fiscal consolidation. What is going on?"

A good question.

It is important to be clear about what is happening. Even amongst people who should know better there is a tendency to present the slowdown in the recovery as being unrelated to the government's fiscal austerity programme. So in their recent analysis in the FT Chris Giles and Andrew Bounds suggest that

A core problem has been deficient growth, which has persistently fallen short of expectations and kept unemployment well above the levels of most of the 1990s and 2000s. ..... Most economists see the fierce political arguments as of little relevance to the question of why the economy has disappointed expectations so greatly. The Office for Budget Responsibility, the independent body charged with advising on the public finances, explains its forecast downgrades not with reference to spending cuts or tax increases but by "higher than expected inflation squeezing household incomes and consumption".

It would be easy to read this and conclude that fiscal austerity is not slowing the economy and that the slowdown is due to a reduction in real personal disposable incomes due to higher inflation than expected.

Of course Giles and Bounds are not talking about the slowdown in the recovery per se. They are actually discussing why the OBR got its forecasts for 2011 badly wrong. This is a different issue. The following chart, again from the OBR, shows the outturn and OBR's forecast for the contribution of government spending to UK GDP growth in subsequent forecasting rounds.

What is clear from this is that government spending in 2010 made half the contribution to growth as in 2009. In 2011, which contains a forecast for the fourth quarter and outturn for the first 3 quarters, government spending again made a positive contribution to growth, all be it somewhat less than in 2010. The reduced contribution of government spending to growth represents the direct effect of the fiscal spending consolidation so far.

It seems probable that the positive contribution to growth in 2011, when the OBR had previously been forecasting a negative government spending contribution, is the result of the effect of automatic stabilisers on spending. The effect of automatic stabilisers is usually considered in terms of transfer payments such as unemployment benefit and tax receipts but there is academic research evidence that current spending on goods and services by government also has a counter-cyclical element.

The other side of this coin is the OBR's failure to forecast accurately the contribution of household demand or private consumption to GDP growth in 2011 as this chart shows:

The large negative contribution of private consumption to growth in 2011 may have been heavily influenced by "higher than expected inflation squeezing household incomes and consumption." But the drop in household spending may also have been due to the net effect of tax rises, such as the VAT increase, on real incomes.

The OBR's forecasts for 2012 to 2016 envisage a recovery mainly in private consumption, business and dwellings investment, with net trade contributing weakly to growth over the period. The switch from domestic demand to external demand appears temporary - see first chart. The direct effect of fiscal austerity on spending is forecast to bite from this year and gets progressively worse to 2015 and 2016. But the forecast deploys assumptions about private consumption, which, even with inflation falling back to a target 2%, seem 'heroic'.

I expect that the radical difference between the OBR's forecast and the outturn for private consumption seen in 2011 may be seen again over this forecast horizon if the present fiscal policy stance persists.

Posted at 12:36 AM in Household spending, Macro-policy, Public spending, UK economy | Permalink | Comments (0)

08 January 2012

Raising the inflation target

I'm grateful to Douglas Fraser for drawing attention to my argument that the UK and Scottish economies would benefit from a temporary increase in the inflation target. I would favour a rise to 4% for at least 3 years, or until the economy moves much closer to the so-called "natural rate of unemployment" - usually considered to be attained when actual unemployment falls to around 4% to 6%. This is not an original idea. Paul Krugman has proposed a version of it for Japan in the late 1990s, and recently for the US, UK and Eurozone. Warwick University's Professor Nicholas Crafts, the pre-eminent economic historian, has recently noted

In the early 1930s, ..... the key to recovery was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates by raising the expected rate of inflation. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. Fiscal stimulus was not a factor in the UK recovery until after 1935 when rearmament began.

A close approximation to the successful 1930s policy would be to commit to a price-level target which might entail an average rate of inflation of about 4 per cent for three years. Crucially, this would have to be clear and credible so that the inflation was fully anticipated by the public and it would work by reducing the real interest rate.

A theoretical justification for this approach is that when nominal interest rates are at a lower, or zero, limit, the supply of savings may be greater than the demand for savings for investment in plant, machinery and buildings. Pushing the real interest rate lower by raising the price level will reduce savings, since the incentive to save is reduced, and consumer demand will rise. Further, the lower real rate should, along with the increased demand for goods and services, raise investment as well - see note below. Aggregate demand in the economy will rise and the deficiency of demand - excess savings - will be removed. In addition, a stable increase in wages and prices will reduce the real value of outstanding debt and raise some asset prices such as housing. The real debt overhang will be reduced and the incentive to spend will increase. The rise in prices will raise the real exchange rate and lower competitiveness but the nominal exchange rate - sterling - should fall thus preserving the balance between exports and imports.

The main objection is the fear that an attempt to promote an inflation target of 4% rather than 2% may promote an inflationary spiral. However, the risk of this at this time would appear slight, there is excess supply, or a deficiency of aggregate demand, and the rate of unemployment is almost certainly above the 'natural rate,' or the rate below which inflation accelerates. Small savers will also suffer along with other creditors but a more buoyant economy, with more jobs and income should boost share prices and the returns to share ownership and such forms of saving.

It worked in the 1930s. We should try it now.

Technical(ish) Note

This discussion is in terms of the loanable funds theory of the interest rate. The following diagram illustrates the savings and investment relationship to the interest rate at full employment

Source: Krugman

r is the real rate of interest, Investment I is a negative function of r, and Savings S is a positive function of r. Excess savings can only be removed by the real interest rate falling below zero until desired investment and desired savings are equal. What this model does not allow for is that at less than full employment savings and investment also depend on GDP or output. So in these circumstances the supply and demand for funds isn't enough by itself to determine the interest rate. It tells us what the interest rate would be depending on the level of GDP. To fix the interest rate you therefore need to determine the level of GDP and this is achieved by adding "liquidity preference", the supply and demand for money. In the situation depicted in the chart where there is an excess of savings at zero interest rates and so unemployment occurs, we can remove the excess savings by additional government borrowing - fiscal policy - which would shift the 'I' curve to the right effectively "mopping up" the excess savings as GDP increases. However, if we cannot use fiscal policy for political, or even market confidence reasons, then a 'cheap money' policy should do the trick.

Posted at 07:28 PM in Macro-policy, UK economy | Permalink | Comments (0)

03 January 2012

Thoughts from the City

An example of what passes for economic analysis amongst some economists. In responses to a survey by the FT of 83 economists on the state of the UK economy and economic policy in 2012, we find:

Andrew Hilton, Centre for the Study of Financial Innovation:

I do think Ed Balls should be shot. While I have little time for Cameron et al, I have to admit that Osborne has done a brilliant job of (just about) keeping the markets onside. Given that everything Noyer, Fillon and Baroin have said is true, it is astonishing that the markets have been as forgiving as they have been. Perhaps there were one or two traders in the Bullingdon.

Posted at 04:21 PM in Macro-policy, UK economy | Permalink | Comments (0)

31 December 2011

Sharpening up the act

There has been a flurry of statements in the last few days from business organisations, political parties and newspaper editorials urging the Scottish government to in the words of CBI Scotland "sharpen up its act" over the economy. These statements are in response to the weak performance of the Scottish economy and poor short-term prospects.

Scotland, is of course little different from most of the western world. The recovery is faltering as households and organisations continue to reduce their historically high levels of debt as asset prices have fallen. Moreover, the Eurozone crisis is further damaging business and consumer confidence, which is depressing demand for goods, services and investment goods further. Further evidence of the problem was provided by Lloyds TSB Scotland quarterly Business Monitor (no link), conducted by the Fraser of Allander Institute at the University of Strathclyde. Key findings were the large drop in export demand, net falls in company sales and falling business and consumer confidence.

Hence, the need, according to the statements, for the Scottish government to "sharpen up its act."

This begs the question what reasonably can we expect the government of Scotland to do. To answer this question we must ask what the problem is before we consider how best to address it. The problem? This clearly is a deficiency of overall demand for goods and services and hence jobs in the Scottish economy given the available quantity and quality of resources of the current workforce and the stock of plant, machinery and buildings. So, the first point to make is that the problem is not about "growth" in the strict sense of the term. Growth and growth policy is about increasing the quantity and quality of available resources in the Scottish economy. This is what economists call the 'supply potential' or 'supply capacity' of the economy. The current problem is not supply potential. There is plenty of that. GDP is still probably around 10 percent below where it would have been in the absence of the recession that we are recovering from. Accordingly, many of the criticisms made of the Scottish government and much of the response from the Scottish government are about policies that might improve the long-term supply potential or 'growth' of the economy. They are not about ways of improving the utilisation of existing capacity.

To improve the utilisation of existing capacity, the demand for goods and services produced in Scotland needs to be increased. This is more difficult for the authorities of a small open economy, no matter whether it is a sovereign state or a 'region' of a larger state or monetary union. The two charts below show the composition of final demand for goods and services in Scotland and the UK in 2007.

What is clear from the charts is that exports are more significant to Scotland, at 30% of final demand, than they are to the UK, 21% of final demand. So, the demand for Scottish products is more dependent on factors outside its borders than is the UK. Government consumption amounts to the same percentage of final demand, 16%, in Scotland as in the UK. However, it is clear that the level of government spend in Scotland is determined by the block grant to the Scottish Parliament, which is determined by the Barnett formula, and spending by UK government departments in Scotland. The UK government is undertaking, for better or worse, a programme of fiscal consolidation and so both government consumption and the proportion of capital formation that is spent by government, is reducing. Again, this is out of the hands of the Scottish government. This need not mean, of course, that this justifies Scottish independence because the unknown counterfactual of that state could involve Scotland with lower or higher government revenues and spending, and its own programme of fiscal consolidation. Nobody knows.

So, to focus on what the Scottish government can do to stimulate demand immediately or in the near future, the options are limited. It can try and divert or switch some government spending to areas where the multiplier is higher. That is where it will be more fully spent in Scotland and not saved or used for imports, or reduce the burden of hiring extra workers that is, reduce the marginal cost to businesses of adding employees. Clearly, targeting the unemployed is one of the best options - see this earlier post - but there are few levers available to the Scottish government to reduce the marginal cost to firms of adding employees. The government might also encourage Scots to spend more on locally produced goods by importing less and to save less. But the former runs the risk of retaliation from other countries and the latter would be difficult to achieve. Finally, some emphasise spending on capital infrastructure. While this will certainly add to capacity and help with growth in the long-term, such projects take time to get up and running. Moreover, as the CBO evidence shows in my earlier post, the return in terms of full-time jobs per pound spent is not high.

So we see that if the proper focus is raising demand in the Scottish economy in the here and now, the policy options available to the government of a small open economy, in current circumstances, are much more limited than some might think.

Posted at 05:21 PM in Macro-policy, Scottish Economy | Permalink | Comments (0)

23 December 2011

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.

Posted at 11:40 AM in Eurozone, Macro-policy, UK economy | Permalink | Comments (0)

19 December 2011

A short-term fiscal Stimulus

Back in November I argued in the Fraser of Allander Institute's latest Economic Commentary that the sluggishness of the UK and Scottish recoveries meant there was still scope for some fiscal easing without damaging our fiscal credibility in the long-term. When pressed later by journalists on what specifically should be done I mentioned raising unemployment benefits and cuts in national insurance. The former because household in receipt of unemployment benefit would almost certainly go out and spend it quickly (Technical: the households have a high current marginal propensity to consume). The latter because it would inter alia reduce the marginal cost to firms of hiring additional labour.

The argument for increases in unemployment benefits was met with hostility in comments from Scottish business organisations and in some letters to newspapers from supporters of the UK government's current austerity policy.

Here is some supporting evidence from the Congressional Budget Office (CBO) of the United States in testimony to the Committee on the Budget of United States Senate on 15 November 2011. See chart:

The CBO conclude that

Policies that would have the largest effects on output and employment per dollar of budgetary cost in 2012 and 2013 are ones that would reduce the marginal cost to businesses of adding employees or that would be targeted toward people who would be most likely to spend the additional income. Such policies include reducing employers' payroll taxes (especially if limited to firms that increase their payroll), increasing aid to the unemployed, and providing additional refundable tax credits in 2012 for lower- and middle-income households.
Policies that would primarily affect businesses' cash flow but would have little impact on their marginal incentives to hire or invest would have only small effects. Such policies include reducing business income taxes and reducing tax rates on repatriated foreign earnings.

But the CBO warn that

If policymakers wanted to boost the economy in the near term while seeking to achieve long-term fiscal sustainability, a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it later in the decade.

Posted at 02:38 PM in Household spending, Macro-policy, Public spending | Permalink | Comments (0)

Scottish Economy Watch

Elizabeth Ashcroft