Scottish Economy Watch

After the fall: state of the UK economy

Is the fourth quarter 2011 fall in real GDP of 0.2% a harbinger of worse to come, or just a blip? The question cannot be answered with much certainty. However, the Economic Review that was published by the ONS today along with the estimate of fourth quarter GDP does provide some food for thought.

Overall, the economy has still to recover 55% of the output lost in the recession. That is, GDP is around 4% below its pre-recession peak. It is the production sector and construction that is displaying the greatest weakness, with manufacturing (-0.9% in the quarter) contributing most to the decline, while the service sector slowly recovers - see chart:

But mining and quarrying also contracted by -1.1% in the quarter and the ONS cites the drop in North Sea Oil production as a key factor. Indeed, the sustained weakness of oil production in the UK is shown to be a contributory factor in the weakening UK trade position.

The ONS notes

The deficit on trade in petroleum and petroleum products of £4.5 billion in the three months September to November is almost three times the £1.4 billion deficit in the same period of 2010. An important factor behind this fall has been a 16 per cent drop in crude oil export tonnage as a result of falling North Sea output. The volume of crude oil exports has now fallen by about 20 per cent from 2009 levels, and has more than halved since 2001. The corresponding volume of imports has increased by nearly 40 per cent since 2001, and by more than 11 per cent over the past year.

On the day that Alex Salmond launches his pitch for Scottish independence these oil production and trade figures must be a major worry for the nationalist cause.

The near term prospects for production output, which contributes 15% to overall UK GDP do not look promising, as this chart shows

Most of the broad product groupings are either exhibiting a downward trend or flat growth. The downward contribution of energy is clear, as is the contribution of intermediate goods. Moreover, both consumer durable and non-durables are contributing little to growth, with no sign of an upturn. This clearly reflects the state of UK consumer demand as households continue to pay down debt and deal with declining real incomes.

And services?

The ONS Review highlights the role of Government & other services in recent growth as the chart shows.

The performance of Business services & finance is encouraging and should support future growth. But with fiscal consolidation beginning to bite the contribution from Government & other services might be expected to diminish.

The recovery was meant to be based on a switch from domestic to external sales, from consumption to investment, and from public to private. There is little evidence of this occurring much in these latest statistics.

These data suggest that we might expect to see more negative GDP growth in the UK in the first half of this year, or at best stagnation.

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.

S&P downgrade no comfort for Osborne

The S&P statement following yesterdays credit downgrade of France - downgraded from AAA to AA+ - and other Eurozone countries should offer no comfort to George Osborne, Germany and those who argue that it is fiscal austerity that is preserving the UK's triple A status. The statement from S&P indicates that it considers the focus on austerity in the periphery to be self-defeating and that it is as much about preserving demand and growth as about effective fiscal management and austerity. I quote at length from Reuter's publication of the statement

The agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone's financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone's core and the so-called "periphery." As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

The decision to downgrade the US on 5 August 2011 from AAA to AA+ had a quite different rationale, largely being about ineffective fiscal management and a failure to address long-term debt issues:

We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.

However, as I noted in this post the rating agencies don't necessarily get their judgement of sovereign debt correct and the markets know it hence look at what has happened to the yield on US 10 year Treasuries since.

Yes, the yield has fallen from 2.56% to 1.86%! Other things matter as well as agency ratings.

.... and UK producer prices are softer

The data on producer prices for December published by the ONS this morning provide further evidence of a weakening in both the domestic and global economies.

Output or 'factory gate' prices for all manufactured products fell by -0.2% between November and December, while the rate of increase over the year reduced from 5.4 per cent in the year to November to 4.8% in the year to December.

Removal of more volatile products such as food, drink and fuel also shows a fall in the rate of increase to 3% over the year.

Some of the fall in output prices reflects a weakening in input prices particularly in imported commodities and oil as global demand weakens.

But as the chart shows, the rate of increase is also declining even when more volatile products such as food, drink and fuel are removed.

These data offer a further pointer to the expected slowdown in consumer price inflation as the year goes on.

UK production is falling

The latest data on production and manufacturing output in the UK published this morning shows output in the production industries falling by 0.6% in November over October and by 3.1% compared to November 2010. While production only accounts for a small percentage of overall GDP - 15.4% - this may be a pointer to a likely fall in overall GDP in the final quarter of last year.

Manufacturing - accounting for 67% of production - did better but still fell by 0.2% during the month and by 0.6% over the year. Mining and quarrying fell by 2.2 per cent and Oil and gas extraction fell by 2.1 per cent in November. Energy supply fell by 2.2 per cent. Gas supply was the main driver falling by 12.3 per cent, with reduced demand for gas used in the production of electricity the main reason for the decrease. The likely reason for the fall in energy supply was that both October and November 2011 were unusually mild in comparison to previous years.

The chart shows the downward trend in production since September 2010 and the relatively flat performance of manufacturing during that period.

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.

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.

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.

Financial services and the recession

It is a truism that financial services in general and the banks in particular played a key role in the speculative bubble that led to the recent Great Recession. We know from the published Scottish GVA data that Scottish financial services contracted rapidly while output volumes held up better in the UK. Between 2007 and 2009 financial services real GVA fell by about 7% in Scotland, while GVA in UK financial service rose slightly by 0.3%. The recently published Regional Economic Activity (GVA) data allows us to analyse sectoral performance across the UK regions up to 2009. What is slightly surprising from these data is just how much the share of the financial service sector rose in each region between 2007 and 2009 - see chart.

These data are expressed in nominal terms. They show the share of UK financial services rising by more than 2 percentage points from 8% to over 10%, while its share in London rose by 4% points from 17% to 21%. The share of financial services also rose in Scotland from 7% of total GVA to 9%, despite the large drop in volume.

So, what is going on here? It is not clear. There may be some differences in the two data sources. There may also be the effect of timing as more volume was lost in the sector after 2009. But there is still a puzzle.

Is it because firms in the sector were able to push up prices and charges? Anecdotal evidence from many firms in receipt of loans suggests that that did happen. The Governor of the Bank of England is on record as being concerned about the lack of competition in UK banking and the funding of SMEs. But, on the other hand, competition in the sector is high from the evidence in international studies. For example, the UK ranked 11th out of 49 on a sophisticated measure (H statistic) of competitiveness of its banking system in Claessens and Laeven, 2004. Also a high degree of competition in banking can encourage excessive risk taking and cause problems similar to those that led to the credit crunch.

But still there is a puzzle here. Anyone got any views?

UK 3rd quarter GDP revision

Today's release from the ONS revised up the estimate of UK GDP growth in the third quarter to 0.6%, but revised down second quarter growth from 0.1% to zero. The first release reported real GDP growth of 0.5% in the third quarter which was above the anticipated 0.3%. However, the special factors that temporarily reduced growth in the second quarter: the Royal wedding; two bank holidays; and the effects on supply of the Japanese Tsunami, have now unwound, so that the ONS recommended that the second and third quarters should be taken together. On that basis growth averaged 0.3% in the two quarters, with real GDP still largely stagnant over the past year.

Nevertheless, this is slightly better news amongst a plethora of recent bad news about the economy, notwithstanding the downward revision in the second quarter.

Looking at the contribution to growth of the main expenditure components - see first chart - we see growth was largely the result of firms adding to their inventories. This might be a good omen that firms were anticipating increases in demand in the future e.g. additional demand at Christmas, and so were preparing for it by adding to their stocks. However, seasonal adjustment of the data should have removed that effect unless it was out of the ordinary. The negative interpretation is that there was a shortfall of demand, firms had produced too much and so added to their inventories. I fear that is the most likely explanation. If that is correct we might expect to see flat, or even slightly negative, growth in the fourth quarter.

It is also reassuring to see some pickup in fixed investment, which made a small contribution to growth in the quarter. But household demand remains very weak with no contribution to growth in the quarter and the savings ratio rising again - see chart. And net trade made a negative contribution to growth. If anybody needed reminding the UK government predicated the economic recovery on strong growth in exports and investment.

Government consumption made a negligible contribution. The ONS notes that this reflects the continued squeeze on expenditure.

The ONS sums up with this cautionary note:

The profile of GDP growth in recent quarters continues to point towards a rather fragile economic picture. During the nine quarters of the recovery, the economy has gained just over half of the output lost during the five quarters of contraction.