Scottish Economy Watch

Oil and GDP Growth

The Centre for Public Policy for Regions (CPPR) yesterday produced an important comparison of UK and Scottish GDP growth in 2011. The analysis uses the latest Scottish Government GVA data for the 4th quarter of 2011, which were published on 18 April.

A key finding of the CPPR analysis is that a comparison of overall GVA between Scotland and the UK in 2011 provides a distorted comparison of the relative performance. This is because overall GVA includes all of North Sea Oil and Gas production in the UK figure but only includes on-shore activities in the Scottish figure. A more correct comparison is to compare GVA for the two excluding the extraction of oil and gas.

Normally this matters little if the performance of oil and gas is not much out of line with overall performance. But during the past year oil and gas production fell by 18% and 22% respectively, which has affected UK GDP and export performance as I noted here and here.

The effect of this fall is to dampen UK growth relative to Scotland.

In 2011, overall GVA grew by 0.5% in Scotland and 0.6% in the UK. But when oil and gas extraction is excluded the unfavourable gap between Scotland and the UK widens, with Scottish growth of 0.5% and UK growth of 1%.

I have taken CPPR's analysis further and extend the comparison back to the start of the recession and subsequent recovery. The performance of overall GVA is given in this chart:

And GVA performance, with oil and gas extraction excluded, is given in the next chart:

The charts reveal the dampening of UK growth relative to Scotland when overall GVA is considered. When oil and gas extraction is excluded the Scottish position is broadly unchanged but the UK recovery is stronger.

The main conclusion from this analysis is that the Scottish recovery from recession is quite a bit weaker relative to the UK than many might have believed.

Alternatives to Austerity

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Language of Growth

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

is a deficiency of overall demand for goods and services and hence jobs in the Scottish economy given the available quantity and quality of resources of the current workforce and the stock of plant, machinery and buildings. ..... the problem is not about "growth" in the strict sense of the term. Growth and growth policy is about increasing the quantity and quality of available resources in the Scottish economy. This is what economists call the 'supply potential' or 'supply capacity' of the economy. The current problem is not supply potential. There is plenty of that. .... (M)any of the criticisms made of the Scottish government and much of the response from the Scottish government are about policies that might improve the long-term supply potential or 'growth' of the economy. They are not about ways of improving the utilisation of existing capacity.

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

UK GDP: don't panic, yet!

The latest UK GDP figures for the first quarter of this year revealing a fall of -0.2% should not lead to panic. Yes, we are now in technical recession after a fall of -0.3% in the final quarter of last year. The latest change is largely driven by Construction with Services contributing positively to growth and Manufacturing neither contributing positively or negatively. Production made a small negative contribution but this was due exclusively to a fall in Mining and Quarrying output of -3.6% due largely to the fall in oil and gas extraction. The contribution of broad sectors is shown in this chart:

The latest GDP data from the ONS are likely to be revised upwards because they reveal a much weaker picture than revealed by UK business surveys. The latest PMI construction surveys stand in marked contrast to the ONS data as this chart shows:

Business surveys generally appear to suggest that the slowdown noted at the end of last year is beginning to turn round see here, here and here. We should see some positive growth in the second quarter.

But it is going to be a hard slog.

None of this detracts from my view that we are enduring a weak recovery largely because of the UK Government's austerity programme. Gavyn Davies' recent FT blog charts the weakness of the UK recovery against the other G7 countries and the contrast is quite marked see chart:

Source: Gavyn Davies

He is more sanguine that the current UK policy mix favouring a much looser monetary and exchange rate policy than elsewhere but tighter fiscal policy may start to generate growth dividends in the future. I am much less sanguine because with interest rates close to zero - the zero bound - monetary policy effects on demand and growth are much weaker than in normal times.

In the meantime, UK GDP now stands at 4.3% below its pre- (2008) recession peak, austerity continues and the situation in the Eurozone has worsened again.

OECD forecast: gloom but not doom

The British media got quite excited this morning by the OECD's latest interim forecast. Many ran headlines such as "Britain back in recession". But as I note in a short article in today's Scotsman, the OECD's forecast is not something that we should get too excited about. The predicted 'recession' is minimal and not forecast to continue. Moreover, the published forecasting errors for the OECD model are quite large for the UK, with the OBR forecasts falling within the OECD error range.

The chart shows the OECD forecast for the first half of 2012 in annualised terms compared to the OBR. It is smaller than the OBR's forecast but still positive. So, no recession is forecast in any meaningful sense. The OBR forecast for the second half of this year is also included. There are no OECD forecasts for the final two quarters of the year because the interim assessment only looks forward two quarters. Now while the OBR are clearly more bullish than the OECD, the difference is only a matter of degree. In its November Economic Outlook the OECD said of the UK

Growth will start to pick up during 2012 as exports and household consumption recover, with further strengthening in 2013.

While things have softened a little since November, I doubt the OECD has revised that judgment.

We must beware projecting concerns about the effect of fiscal austerity onto each piece of data or forecast that emerges. The recovery continues to be weak and that is due mainly to fiscal austerity. But that warrants gloom not doom.

The price of austerity?

The latest revision published by the ONS today shows that UK GDP fell by -0.3% compared to -0.2% in the two previous estimates. This new information doesn't tell us much except help confirm the weak recovery. GDP now stands just over 4% below its pre-recession peak after a peak-to-trough fall of more than 7% in the recession. The US in contrast attained its pre-recession output peak in the second half of last year. So why has the recovery in the UK been so much weaker than in the US? Adam Posen, the US external Member of the Bank of England's MPC has essentially one answer: the UK government's fiscal austerity programme. There are other differences between the two economies that led to a slower recovery in investment and consumption in the UK. These include a poorer allocation of credit in the UK, the greater spillover of risk from the euro crisis and bigger impact of energy price rises. But they pale when compared to fiscal austerity. Posen estimates that

Cumulatively, the UK government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households.

An examination of the GDP data shows that the recovery began to weaken in the third quarter 2010 a few months after the Conservative-Lib Dem coalition came to power and Osborne's June emergency budget when £6 billion was immediately taken out of the economy. For budgetary reasons, Scotland's share of this cut was postponed until the next financial year. The charts below show what the recovery would have looked like if the pre-2010q3 recovery had continued in both UK and Scotland.

These charts suggest that both the UK and Scotland would have attained their pre-recession GDP peak in the second quarter of this year, not too long after the US. The estimates also reveal that to the latest data point UK GDP is 3% below where it would have been, in relation to the pre-recession peak GDP, if the earlier rate of recovery had continued. Cumulatively, that amounts to a 10% loss of GDP compared to the pre-recession peak. Is that the price we have had to pay for the UK government's austerity policy?

Is Osborne "Browned" Off?

I suspect I am not alone in being a little disconcerted when I see images like this

Then when I read what the IFS said yesterday about the Budget

We do not know with anything like such certainty that the cut in the 50p rate will cost only £100 million. We do not know that the proposed caps on tax reliefs will bring in the £300 million or so the Chancellor is banking on. Nor do we know that the stamp duty changes will raise the nearly £300 million that he has pencilled in. .... (There is a) risk that Budget measures end up being a net giveaway.

And I remember this

I wonder if Mr Osborne is what he seems. Does this explain why Gordon hasn't been seen much around Westminster lately?

UK Productivity Conundrum

The data today from the ONS confirm the deterioration in UK labour productivity. The release notes:

UK labour productivity on an hourly basis was 12 index points (equivalent to 11 percentage points) lower than the G7 excluding the UK in 2010. This is a little lower than the shortfall on a per worker basis, reflecting lower average hours in the UK than other G7 countries, particularly the USA and Italy. However, the UK's shortfall on this measure has increased by six index points since 2006, reversing a long period over which the shortfall had narrowed. And the productivity shortfall has widened against all other G7 countries since 2006. On a per hour worked basis the productivity gap, in 2010, between the UK and the USA was at its widest since 1995 (24 index points) though it is smaller than the gap on a per worker basis.

The deterioration is clear from the chart below, which compares GDP per hour worked for several key G7 countries to the UK = 100. The series starts from 2003 so that we can bring Scotland's UK relative into the picture.

The deterioration does appear to have started in 2006. But it appears to have worsened since the Great Recession began, although in 2010 there was a relative improvement. Scotland's improvement relative to the UK seems to be mainly the result of the recession. The 2006 start suggests it is too simplistic to blame the recession on the UK's relative productivity deterioration, although the ONS cites UK GDP change as a factor in productivity change:

All G7 countries, including the UK, experienced growth in GDP per worker in 2010, reflecting a bounce-back from the global recession in 2008 and 2009. ... All of the G7 countries demonstrated positive growth in GDP per hour worked in 2010. The UK growth in GDP per hour worked resulted from a combination of a fall in average hours worked per worker .... and an increase in GDP.

But output change apart, the reason why the UK's relative productivity performance has deteriorated since 2006 remains something of a conundrum.

Moody's Blues

Jonathan Portes thoroughly demolishes the case that Moody's decision to put the UK's AAA rating on 'negative outlook' should be taken seriously. I have made similar points, although less forcefully, here and here.

The key points are:

• The Ratings Agencies do not know what they are talking about when it comes to sovereign debt.
• UK government debt is denominated in pounds; the government/Bank of England can print more pounds to pay its debts if necessary, so risk of default is zero.
• Moody's economics is wrong. A worsening economic outlook means that the financial markets will move out of more risky assets such as equities into, yes, you guessed it, gilts! And, from recent experience, UK government gilts. Gilt prices should, in consequence rise, and yields fall. The cost of sovereign borrowing therefore falls.
• Forget the Ratings Agencies; the markets will.

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:

1. The buying of useful things raises spending.
2. Financing it by printing money rather than issuing bonds means no increase in interest rates to crowd out private spending.
3. 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.
4. 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.