Scottish Economy Watch

Public Sector Jobs and Fiscal Austerity

Yesterday saw the publication of the public sector jobs data for both Scotland and the UK. I examined in this earlier post what could be deduced about the impact on public sector jobs of fiscal austerity when data for the fourth quarter 2011 were published back in March.

The new data show fiscal consolidation continuing with more jobs being shed. And Scotland still seems to be leading the way as this chart shows:

However, the 8.9% fall in public sector jobs in Scotland includes the banking employment in HBOS and RBS, which were included in the data from the fourth quarter 2008 after the UK government took a majority stake in each. Transferring those jobs to the private sector reduces the fall in public sector jobs to -7.6%. This makes the job loss broadly the same as England.

There is some evidence that the part-time jobs have initially been more vulnerable than full-time jobs. But recalculating the job loss in terms of FTEs leads to an estimated fall of -7.3%, not much different from the percentage fall in the ex banks headcount. But the FTE numbers are smaller.

Overall, some 57,000 public sector jobs have been cut if the banks are included, 44,000 if the banks are excluded, which translates into about 37,000 FTEs. This is still a sizable job loss whichever way you look at it.

It is also worth noting that at the Fraser of Allander Institute, in a CGE model simulation published in the Economic Commentary in June 2012, we estimated that the public sector job loss from departmental spending cuts would likely be in the range 78,000 to 90,000. It would appear, sadly, that we are well on the way to attaining that range of job loss.

The overall public and private jobs position since the start of the Great Recession is given in this chart:

What is again clear from this chart - I have smoothed the data in the absence of seasonal adjustment - is that the recovery of private sector jobs has not in any significant way compensated for the public job loss.

So much for the UK government view that there would be a crowding in of private jobs as the public sector contracted.

Benefits: Ground Control to Sir Tom

Sir Tom Hunter is reported today as believing that Scotland has become far too reliant on the state and that benefits have corrupted the nation's work ethic. He is quoted in the Sunday Times as saying:

The fact is the welfare state has simply enabled us to become pampered, dependent people who expect what others strive and grasp for... For those most vulnerable, most in need in our society, (the welfare state) is sacrosanct. ... However the pendulum, in my view, has swung too far and we expect too much from our state when in many respects we have not earned that expectation.

The basis for Sir Tom's comments is data from the UK Department of Work and Pensions, which reveals that Bridgeton in the east end of Glasgow has 85 per cent of working age adults in receipt of benefit. Further, seven of the ten areas with highest receipt of benefits per working age adult are in Scotland and four of them are in Glasgow.

No one doubts Sir Tom's sincerity. I personally stand in awe of his philanthropy and his magnificent contribution to the promotion of entrepreneurship in Scotland and the good of economy generally. But on this issue I fear he has not been well advised. Indeed, it might be said that he has inadvertently played into the hands of the present DWP and its benefit cutting agenda.

No one doubts that Scotland has too many people locked into a cycle of extreme deprivation and disadvantage. Many of them are located in the Glasgow area. It is a tragedy that more is not being done to break the cycle and assist them to attain a state where they no longer need to rely on benefits.

But is Scotland much out of line with the rest of the UK? Indeed is Glasgow?

The chart below shows benefit expenditure per voter - electorate - in England, Wales, and Scotland:

Yes, benefit spending - data exclude housing benefit and council tax benefit - per voter is higher in Scotland than England by 9 percent. But spending in Wales is higher than in Scotland also by 9%. Hence Scotland is not dramatically out of line with the rest of Britain.

So, what is going on?

What Sir Tom, and I think also the DWP, may not properly understand is that the interaction of the jobs market and the housing market leads to the spatial concentration of different social groups within a city. So, if I do well at my work and get promotion I might be able to buy a house in the West End or over in the South side. But, if I lose my job and can't keep up my mortgage payments I may lose my house and eventually move into social housing in Bridgeton or Rutherglen.

What we see from that stylised example is that the unemployed and benefit dependent families tend over time to concentrate in certain areas. On the other hand, the better-off, upwardly mobile, go to the West End, South side, or just outside Glasgow to places such as Bearsden. Hence, the high proportion of benefit recipients in Bridgeton. (On housing market segmentation see inter alia Christine Whitehead here.)

Don't believe me?

Well look at this chart

Benefit Spending per voter in Scottish Westminster Constituencies 2010-11

The chart may be difficult to read but it shows the benefit spending per voter in each UK Parliamentary constituency in Scotland. The spend in the median constituency is £2,813 a little lower than the mean of £2,832. At the lowest extreme stands the West Aberdeenshire and Kincardine constituency with a spend of £2,016 per voter, while at the top of the spending range stand 3 Glasgow constituencies. The one with the highest spend of £3,756 per voter is Glasgow North East, closely followed by Glasgow East at £3, 724.

But note: there are 3 Glasgow constituencies with a benefit spend below the Scottish median and mean: Glasgow South (£2,782), Glasgow Central (£2,666) and Glasgow North (£2,382). Indeed, Glasgow North has the sixth lowest spend in Scotland and is below the average for England.

Scotland clearly has problems of multiple deprivation leading to higher levels of benefit spending than in England. But less than in Wales. The incidence of this deprivation and need for benefits is clearly in Glasgow. Yet, within cities poor deprived people tend to live in certain areas while the better off live in other different places.

It is also probable that concentration of large numbers of deprived individuals and families in one area may make it harder for many to escape the stigma of deprivation see this book especially Ch 4 by Alan McGregor. And some of these may become dependent people.

But Sir Tom, there is no evidence of pampering. Nor is there evidence that Scotland has become far too reliant on the state, or that benefits have corrupted the nation's work ethic.

Scotland and Glasgow's problems of deprivation and benefit dependency are far more complicated than that.

Scotland's fiscal position

Yesterday (18 April) the Scottish Government published along with its latest quarterly GDP figure a long-run series for Scottish and UK GDP in current terms going back to financial year 1980/81. The novelty of the series is that the GDP estimates for Scotland include a population and geographic share, respectively of North Sea oil production (technically a share of extra-regio activities). These data can be combined with the data on Scotland's and the UK's net fiscal balance going back to 1980-81, which were published on 7 March of this year. It is worth noting that the data are classified as 'experimental' as part of the Scottish National Accounts Project (SNAP) and so do not carry the Office of National Statistics (ONS) 'kitemark'.

With these new data it is now possible to compute an estimate of Scotland's fiscal balance since 1980-81 and compare with the UK. I have done this for the case where Scotland is allocated a population share of oil production and revenues and for the case where Scotland is allocated a geographic share of oil production and revenues. The estimates of the geographic share are based on the methodology and modelling of Kemp and Stephen (2008). For a sample of their earlier work on North Sea oil see their 2001 and 2005 papers.

The charts for the two cases are below

There is something in these figures for both proponents of Scottish independence and those who advocate staying in the UK union.

The table below tries to draw some conclusions on the fiscal balance by first taking averages for the whole period up to the start of the Great Recession in 2007-08. The period after 2007-08 is excluded because I assume that it is untypical. It is clear that with a geographic share the Scottish position is far superior to the UK. Both are above or better than the 3% deficit which is the limit set out in the EU Stability Pact. This is the figure that would probably be demanded of Scotland as the limit of its deficit within a sterling union. But Scotland's favourable position is seen to depend on oil revenues. When Scotland is allocated a population share of these revenues the fiscal deficit deteriorates to -5.3%, clearly above 3%.

The second set of estimates is based on the period 1990 to 2007. This excludes the initial rush of oil production as the North Sea boomed and oil revenues were exceptionally high in real terms. On this basis, even with a geographic share, the Scottish fiscal deficit is averaging slightly above 3% and above 6% if only a population share of revenues is allocated. The UK remains under 3% in both cases.

Fiscal balance as % GDP		Sco average 1980 to 2007		UK average 1980 to 2007	Sco average 1990 to 2007	UK average 1990 to 2007
Geographic share oil revenues		1.5		-2.4	-3.6	-2.6
Population share oil revenues		-5.3		-2.4	-6.5	-2.6

Of course, production of oil and gas in the North Sea is set to decline. There is a question mark about the rate of decline because it depends on oil prices and the extent of new discoveries. The best estimate is provided by Kemp and Stephen 2011 and is based on a real oil price of $70 per barrel and a gas price of 40p per therm - the oil price will be higher than $70 in nominal terms because of inflation. This scenario has for them the greater probability than a $90 and 60p combination.

The time profile of hydrocarbon production is shown below

Of course, we don't know what this implies for oil revenues because it also depends on the tax rate, as well as the price of oil and gas, and levels of production.

The main conclusion would appear to be that an independent Scottish government cannot rely indefinitely on oil revenues to ensure that it remains below the 3% deficit benchmark over a sustained period. But it can probably do so for a reasonable period. In the longer term, other sources of tax revenue will need to be found and/or public spending shares reduced.

Amazon and the Scottish Government

Amazon has avoided paying corporation tax over three years on UK sales of more than £7.6bn. The company has been rightly criticised for this. But the Scottish Government has also come under criticism for paying Regional Selective Assistance grants and other public support amounting to £10.6 million. The support has been given to Amazon's fulfilment and distribution centres in Dunfermline, Gourock and also a customer call centre in Edinburgh.

You can see the vulnerability of the Scottish Government's position when one of its economic arguments for an independent Scotland is the opportunity it would be given to lower the rate of corporation tax to attract new inward investment and so, it hopes, promote the growth of the Scottish economy.

Whatever one might think about this argument for an independent Scotland is it right that the Scottish government should be criticised because Amazon has avoided paying corporation tax?

I think the answer to this question is an emphatic no!

The payment or non-payment of tax is a separate issue from the contribution of Amazon activities to the Scottish economy. Clearly, HMRC should do everything in its power to ensure that Amazon cannot indulge in sophisticated transfer pricing arrangements to avoid paying UK tax. But whether Amazon should have invested in Scottish activities with Scottish Government support depends on the estimate of the net contribution of activities to the Scottish economy.

It appears that with the investment last year Amazon will have around 1000 jobs in Scotland. To criticise Amazon's business model and the quality of the jobs provided as some have done is again a red herring. The critical question is what would the counterfactual have been to the investments? In non jargon: what would have happened if the Scottish government had not paid the £10.6 million to Amazon in grants?

First, if Amazon would have come to Scotland anyway then there would have been no additionality and the Government support would have been a mistake. But the project will have gone through a significant appraisal process by Scottish Government economists and civil servants. They must have concluded that there was a high probability that the investments would have gone to another jurisdiction, probably Ireland. Nobody appears to have criticised the support as lacking additionality. And if the project is additional then there would be secondary multiplier effects creating further jobs from the spending from the incomes earned in the newly created jobs and from any local purchases made by Amazon's Scottish investments.

Secondly, would the £10.6 million have been better used by Scottish companies? Nobody knows for certain. But I doubt it. There is no evidence of competing Scottish owned investments complaining because they could not get grants. Indeed, given Scotland's weak business birth rate this is one key reason why the Scottish government needs to hunt for inward investment. There is currently no domestic Scottish alternative.

Thirdly, would Amazon's Scottish investments have led to the displacement of other Scottish activity? This would also have formed part of the Scottish Government's ex ante appraisal of its support for the investments. Displacement could occur through the jobs market if the incoming investment bids up local wages. This again seems unlikely when unemployment is so high. I doubt no Scottish employer had to shed jobs due to higher wages following Amazon's creation of 1,000 jobs. Displacement can also occur through the goods market. That is Scottish produced goods and services may be displaced as Scottish consumers switch away to buy the Scottish Amazon product. Is this likely? Again I think the answer is no. To argue as some have done on Twitter that the demise of Waterstones and other booksellers based in Scotland is due to Amazon's Scottish investments is risible. Yes, their demise may be due to Amazon but not to their Scottish investments. That would have happened wherever they located.

So, we should welcome Amazon to Scotland, while criticising strongly their apparent tax avoidance. And on this occasion, we should give the Scottish Government a break.

Public procurement: the bottom line

The report by the Cuthbert's for the Jimmy Reid Foundation into the public procurement system in Scotland finds

that the overall process of public procurement in Scotland is not working satisfactorily from an economic and social development perspective. In many cases, contracts have been made very large and there are significant barriers to participation by small and medium sized enterprises. Procuring bodies also find it difficult to reflect social and economic requirements in their procuring decisions. This reflects, to a large extent, the big business friendly/low burden approach .... This unsatisfactory outcome, however, is not inevitable. Evidence from elsewhere in the EU indicates that much more can be done within the scope of the EU Directive, for example to assist the involvement of small to medium sized enterprises.

The report provides a thought provoking critique of the present system and makes a strong case for greater involvement by Scottish small to medium sized firms in public procurement. This could have job creation and economic development advantages.

What the report does not, however, say clearly enough is that in the final analysis the interests of the Scottish tax payer and consumer of public services must be paramount. The Scottish government must purchase from suppliers that offer the best quality, reliable delivery and at the lowest cost. There may be an industrial policy argument for subsidising through the procurement process certain 'infant' companies or industries. But there has to be a strong expectation that these supplier firms and industries would become the best quality, lowest-cost suppliers in the future.

The adoption of a mercantilist policy in the end benefits neither the Scottish tax payer nor small and medium sized firms in Scotland

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.

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.

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.