Scottish Economy Watch

No End to Austerity

Several UK newspapers today trumpet the Chancellor's Autumn Statement yesterday as heralding the end of austerity. Nothing could be further from the truth.

Chart 4.10 in the Office for Budget Responsibility's (OBR) Economic and Fiscal Outlook shows the size of the state in Britain continuing to shrink dramatically.

From around 46% in 2010-11 total public spending as a percentage of GDP is projected to fall to 36.4% in 2020-21. This is as low as it was in 2000-01 after the long decline from around 48% after eighteen years of Conservative government - the 1997 Labour government initially adopted Conservative spending aggregate plans in an attempt to gain fiscal credibility. Prior to 200-01 the last time total public spending amounted to around 36% of GDP was in the mid 1950s.

The Chancellor may have done a U-turn on his plans to cut tax credits but he still hopes to cut the size of the British state by 20% in ten years, twice as fast as the paring back of the state under the Thatcher/Major governments.

Fraser Economic Commentary - June 2015

 

I           Overview

In the latest Economic Commentary we note that the Scottish and UK economies are continuing to grow and recover from the Great Recession. With growth of 0.6% in the final quarter of last year – the latest data point - the Scottish economy has now enjoyed positive growth for the last 11 quarters (since 2012q1) while in the UK, also with growth of 0.6% in 2014q4, the sustained recovery period has been shorter at 8 quarters. But the recovery continues to be stronger in the UK.

When oil and gas production is removed – to compare like with like, since offshore activity is included in the UK but not the Scottish GDP data - we find that the gap in the strength of the recovery widens further in the UK’s favour. UK GDP stands 5.1% above the pre-recession peak compared to only 2.3% in Scotland. We speculate that the relatively stronger UK recovery under the new accounting system ESA 2010, under which the latest data were generated, could be due to the recovery in R&D activity being stronger in the rest of the UK after the recession than in Scotland and, if so, may not augur well for Scotland’s growth performance in the longer term. However, there may simply be a technical rather than an economic cause due, for example, to different sub-sectoral weights between Scotland and the UK.

 

II          Industries and sectors

When we examine the performance across different industries and sectors, we see that the pattern of growth between Scotland and the UK differed considerably in the fourth quarter.  In the UK, the service sector was by far the main driver of growth, while in Scotland the sector made no contribution to growth. In contrast, the principal driver of growth in Scotland was the construction sector while the sector in the UK was a drag on growth. In addition, the production sector contributed about a third of the growth in Scotland but made no contribution to growth in the UK. Within production, manufacturing in both Scotland and the UK made no contribution to growth, while in Scotland it was mining & quarrying and electricity & gas that provided the contribution to growth.

 

III         The labour market

The latest labour market data show that jobs continue to be created at a fairly fast pace, indeed in the latest February – April 2015 quarter at a faster rate in Scotland than the UK both in the quarter and over the year. However, the picture differs on unemployment with the numbers seeking work rising slightly in the latest quarter and the reduction over the year, while sizeable  is proportionately less than in the UK. By the end of the fourth quarter, Scottish jobs as reported in the LFS household surveys were 2.6% above the pre-recession peak, while UK jobs were 4.6% higher than the peak. So, the latest data show the recovery in the labour market to be continuing but there is now some evidence that the rate of recovery is slowing in Scotland and despite recent stronger Scottish jobs growth overall the recovery remains stronger in the UK.

 

IV         Progress of the recovery

Our conclusion on capacity utilisation is that despite the recovery the Scottish economy still has spare capacity available, most notably in the labour market where the number of total weekly hours worked in Scotland was close to but still -0.4% below the pre-recession peak. Moreover, by January - March 2015, the ratio of employment to working population stood at -2.4% below the pre-recession peak, a worsening of the position in the final quarter of last year, compared to -6.7% at the trough of the recession. In the UK as a whole, in contrast, the ratio is only -0.6% below its pre-recession peak but still below a peak that was attained 7 years ago.

 

(i)        Positive influences on the recovery

We note that there are clear positive influences boosting the demand for Scottish goods and services:

• Domestic demand is still growing strongly boosted by investment (see below);
•  Domestic inflation is close to zero, below nominal earnings/income growth and so boosting real income; and
•  External demand remains reasonably strong, with growth in the euro area beginning to strengthen while US growth having faltered earlier in the year looks set to pick up again.

 

 Yet, there are continuing threats to the further recovery of demand which policy should seek to minimise.

 

(ii)       Threats to the recovery

 

•  First, growth remains unbalanced with household spending the key driver fuelled largely by rising household debt, which we fear may soon become unsustainable. The growth of imports continues strongly outstripping the relatively weak growth of exports and so net trade acts as a drag on growth. Policy must seek ways of boosting exporting performance because it is becoming clearer that a more competitive price through a lower sterling exchange rate is insufficient to boost export demand. Issues of product quality and marketing would appear to be at the root of this Scottish and UK problem. One bright spot in this picture of unbalanced growth of demand is the performance of capital investment, which is now contributing significantly to demand and the growth of output in Scotland. Infrastructure spending is playing a big role in Scotland – think the new Forth Road Bridge – but also foreign direct investment where Scotland again enjoyed a successful year in 2014 with over 80 inward investment projects attracted.

• Secondly, the victory of the Conservatives with a small majority in the May UK General Election appears likely to lead to a continuation and perhaps a tightening of the previous Conservative / Liberal Democrat Coalition austerity plans. We shall find out more in the Chancellor’s forthcoming Budget. With more austerity households can expect a further reduction in their incomes, on average. What that means is that household spending will also be reduced and the fall is likely to be greater the more quickly the Chancellor seeks to bring the UK government’s budget into balance. Austerity will continue to be a major drag on capacity utilisation and economic recovery in Scotland and the UK.

• Finally, there is Greece. At the time of writing we do not know the outcome of the negotiations between the Greek government and its creditors. The risks of Greece both defaulting on its debt and leaving the euro have increased since we last reported. This issue is again fast becoming a major threat to the recovery not simply in the eurozone but perhaps, with the possibility of contagion, in the rest of the world, including Scotland.

 

It is against this background that we have prepared our latest forecasts.

 

V          Forecasts

 (i)        Output

Our GDP forecast for 2015 is 2.5%, which is revised down slightly from our forecast of 2.6% in March of this year due to the evidence of a slowing of the rate of growth through the first half of the year. For 2016, we have also revised down our forecast to 2.3% from 2.4% in March, in recognition that while the recovery is continuing the growth of demand is now anticipated to be slightly weaker than previously thought. We also are prepared to acknowledge that the negative effects of the oil price fall on the oil production and services, may be a little greater than we anticipated in March. We are forecasting 2017 for the first time and the underlying determinants suggest that growth will be little different from 2016 and so we retain the forecast of 2.3% for 2017.

 

(ii)       Jobs

The number of total employee jobs is forecast to continue to increase in each year of the forecast horizon 2015 to 2017, and at a faster rate than that seen during 2014 (although not as strongly as in 2013). Our forecast for the number of jobs added in 2015 has been revised down marginally since March’s forecast, from 51,350 to 51,250. The number of jobs at the end of 2015 is now forecast to be 2,444,250, an increase of 2.1% in 2014. Our current forecast is that the Scottish economy will add 49,600 jobs in 2016, down by 8,000 from our March forecast, while we forecast the addition of 51,700 jobs in 2017.

 

 (iii)     Unemployment

Given the small revisions to the growth in employee jobs over the next two years in our latest forecasts, there are only small revisions to the levels and rates of unemployment from our earlier forecasts. The improvement in the labour market is forecast to continue with unemployment rates and numbers falling to end 2017. Our projection for unemployment on the ILO measure at the end of 2015 is 138,200 (5.1%), falling further to 122,364 (4.5%) by the end of 2016, and 108,150 (3.9%) by end 2017. It is worth noting that our unemployment forecast for 2017 means that the unemployment rate finally falls to where it stood when the Great Recession started in 2008, nine long years ago.

IMF was not wrong on Osborne's austerity

 

The IMF has sought fit to effectively apologise for seeking last year to encourage the Chancellor to relax his austerity measures. Yes, they got the strength of the UK recent recovery wrong, everyone did, even Osborne himself. The Chancellor had quietly started to relax the austerity programme after 2012 as Jonathan Portes and Simon Wren Lewis make clear.

What governed the IMF's views last year was the weakness of the UK recovery since 2010 and the subsequent largely austerity driven stagnation that resulted in the UK economy - its level of GDP - still below its pre-recession peak; worse than every major country except Italy as the chart shows.

No, Ms Lagarde there was no need to apologise. You and Olivier Blanchard, chief economist of the IMF, were simply doing your job.

The Budget – an essay in economic illiteracy?

Step back from the detail of Chancellor George Osborne’s Budget today and ask yourself: Does this Budget help the economy to move to a sustained recovery?

Remember we have an economy which is largely recovering on the back of household demand, which is built on shaky foundations: a falling savings ratio, higher borrowing when household debt is still exceptionally high in historical terms and real incomes that continue to fall. Investment is beginning to recover but is exceptionally weak. Net trade too is even weaker in the UK, a little stronger in Scotland.

So what has the chancellor done to ensure a more balanced and sustainable recovery?

On the positive side he has doubled and extended the Annual Investment Allowance estimated to cost £2 billion, which is a significant measure. This should help investment and mirrors what we argued for in the latest Economic Commentary last week. There are measures to help cut production costs such as the £7 billion package to reduce energy costs. These should help competitiveness and may improve export performance and so boost net exports.

But what was the centre piece or show piece measure introduced in this Budget?

A major boost to savings!

Yes, significant measures on ISAs, pension annuities and so on designed to encourage savings. Now think about the economics here: a rise in savings means lower household spending and therefore a reduction in demand in the economy. This at the same time as the Chancellor feels the need to continue his austerity programme further driving demand from the economy.

We do need measures to boost productivity, to improve the supply side. But in the here-and-now it is still demand that is key.

The Chancellor’s economics beggars belief.

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.

 

No double-dip but UK recovery just got worse

The UK Economic Accounts for the first quarter 2013 were published this morning. The UK media - e.g. here - tended to highlight that revisions had removed the double dip recession in the first quarter of 2012. GDP fell in the second quarter but now appears to have remained flat in the first quarter of 2012 rather than falling.

But to me the real story is that the revisions to the data mean that the recession was worse than previously thought with GDP falling by 7.3% rather than 6.3%. Moreover, in the first quarter UK GDP is now seen to be just under 4% - 3.9% - below its pre-recession peak compared to -2.9% before.

The chart below shows the track in recession and recovery of GDP at basic prices and at factor cost.

GDP at factor cost = GDP at market prices - indirect taxes + subsidies, whereas GDP at basic prices excludes taxes less subsidies on products (taxes on products include VAT and excise duties) but includes taxes and subsidies on production other than taxes and subsidies on products.

Any variation between the two measures will reflect changes in taxes and subsidies on production.

With these net taxes removed, and therefore using the measure of GDP at factor cost, we see from the chart that the scale of the recession becomes slightly worse at -7.6% below peak. And the current shortfall below the pre-recession peak of -4.8% is much worse than the position measured in basic prices of -3.9%.

The Chancellor may believe correctly that he has won the argument on austerity with the voters but the data show how specious that claim is.

And a final Scottish thought.

If Scotland's data remain unrevised for the period then the scale of the recession and the current position in relation to the pre-recession peak is much better here: a drop of GDP in recession of 5.6% compared to 7.3% in the UK and 2.3% below pre recession peak here compared to 4.1% in the UK at the end of the fourth quarter 2012.

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.

Little joy in latest GDP data

Today the Scottish government published GDP data for the second quarter and the ONS published jobs and unemployment data for quarter June - August.

On any criteria, the new data do not make encouraging reading, with output falling, the number of jobs contracting and unemployment rising.

In this post, I shall focus on GDP and output, leaving a discussion of the labour market to a later post.

GDP in constant prices fell by 0.4% in Scotland during the quarter, the same loss of output as in the UK. We currently have available only the rounded data but on that basis we get the following chart

Both the Scottish and UK economies have contracted for the last three quarters. This is clear evidence of a recession, although thankfully not as steep as 2008-09. We wouldn't expect it to be as steep of course. Because what we are experiencing is effectively an aftershock of that Great Recession.

Over the year, the Scottish economy has experienced zero growth compared to slight growth of 0.4 per cent in the UK. It seems unlikely that there will be much improvement in that annual growth by the time we reach the end of the year, unless there is a mini-boom in output in the second half of the year. However, all the indications are, from surveys and casual empiricism, that that will not happen.

One issue that stands out from the latest Scottish data is the weakness of the production sector here. Output fell by 3.8 per cent compared to a fall of 0.7 per cent in the UK. The key reason for this was that the performance of Scottish manufacturing weakened considerably in the quarter and that was mainly due to a fall in production in the engineering sector, specifically Electronics (-5.5%), Textiles, Leather & Clothing (-3.8%), Other Manufacturing Industries including Repair (-3.1%), and Refined Petroleum, Chemical & Pharmaceutical Products (-2.4%).

The service sector did a little better here (+0.2% against -0.1% in UK) and construction bounced back (+2.0% against -3.0%) from the large fall experienced over the year. But, on an annual basis both services and construction have performed less strongly here than in the UK as a whole.

A final point on output is that the Scottish recovery is flattered by the statistical quirk that the UK figures include all of oil production whereas the Scottish data do not. With oil production weak this has affected the Scottish-UK GDP relative as John McLaren at CPPR pointed out as I reported here. As the chart excluding oil and gas production, and incorporating the latest data, shows, the Scottish recovery from the Great Recession has been weaker than the UK.

We are still a little over 4 per cent below the pre-recession peak in early 2008 with the UK still 3 per cent below.

On the latest evidence it will be many quarters yet before we return to that peak. And readers of this blog know why!

(More detailed analysis of Scottish GDP, the labour market and future prospects will be provided in the Fraser of Allander Institute, Economic Commentary, which will be published on 7th November.)

 

Barclays

I couldn't possibly comment!

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.