Bill Jamieson: Difficulties with raising rates

Up, up and away & but ballooning house prices in greater London do not a recovery make. Picture:Getty
Up, up and away & but ballooning house prices in greater London do not a recovery make. Picture:Getty
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A more optimistic picture is emerging of our economic progress to challenge the doubters, writes Bill Jamieson

Two critical issues arise from the assessment of Scotland’s economic prospects in the latest Fraser of Allander Quarterly Bulletin. The first relates to its upgraded forecast for Scotland’s economic growth this year. Why, along with other major forecasting organisations, have so many consistently underestimated the strength of recovery?

The second springs from the FoA’s warning that the economy may now be in danger of overheating. It is accompanied by an earnest plea to the Bank of England from the report’s author, Professor Brian Ashcroft, not to raise interest rates. London, he points out, may be experiencing a property price bubble. But this is not at all the case in Scotland or indeed other parts of the UK outside the London area where there is no such evidence of a property market overheat.

There is a third highly salient issue raised in the Bulletin which readers may find more engaging. This is a paper by the academics Dr Nicolas Scelles (University of Stirling) and Professor Wladimir Andreff (University of Paris) on How to predict the winner of the 2014 World Cup (in one simple equation): a new methodology. A brief description of this seminal analysis, together with the equation which I am sure readers will find invaluable, is given at the end of this article.

The good news from the FoA is that it has raised its forecast for Scotland’s GDP growth in 2014 to 2.5 per cent compared with 2.3 per cent previously. This is the third quarter in succession that the institute has had to raise its growth estimate. “The rise in the 2014 forecast,”,it explains, “is the result of the generally better than expected improvement in performance, optimism in business surveys and an improved outlook, especially for investment.”

But as if to quell any suspicion that the FoA has experienced a volte face on its methodology, it quickly adds that it has downgraded its 2015 forecast to 2.2 per cent. And if risks to the sustainability of recovery are not overcome, it adds, “growth could be as low as 1 per cent in 2016”. Hence the lurid headline on the summary: “Burgeoning boom risks bust.”

That we could travel so quickly from boom to bust should not be a surprise to followers of our economic fortunes. But the rapidity of this mooted turnabout is truly stunning by previous standards.

What is arguably as remarkable is the late recognition of the strength of the upturn. Here, to be fair, the FoA is not alone. In recent months major forecasting organisations have had to play catch-up with the UK’s recovery. These range across the Office of Budget Responsibility, the Bank of England, the IMF and, only a few days ago, the EY Item Club.

Why have so many economic boffins got it so wrong? What has been particularly mystifying is the strength of the jobs market, with unemployment falling below 7 per cent much earlier than anyone had expected. As for measuring productivity, the Bank has thrown up its hands in despair.

Economic forecasting has never been an exact science. And for an open economy like ours, predictions are constantly at risk of being smashed by changes in the exchange rate, external demand and fluctuations in consumer mood – and consumer spending accounts for some two-thirds of GDP. Business investment may itself be influenced by the mercurial ups and downs of consumer confidence and behaviour.

Bear in mind, too that our understanding of recent history is subject to constant revision: latest changes by the Office for National Statistics are set to indicate that GDP is greater than previously estimated and that the 2008-9 recession may not have been as severe as widely thought.

That unemployment never reached the peaks experienced in previous recessions has been attributed in large part to labour hoarding: firms retaining staff until demand recovered. But there is another factor that official data finds difficult to capture: the remarkable growth in micro-business start-ups and working from home.

Recent ONS figures show there are now more than 4.2 million people using their home as an office base, up by 1.3 million in the past 15 years and now accounting for almost 14 per cent of the working population compared with 11 per cent in 1998 – the highest level recorded.

Many of these are small business start-ups and in Scotland these are surging. According to Entrepreneurial Spark, more than 27,000 businesses were formed in Scotland last year, up 9 per cent on 2012 and the highest number of company incorporations since records began in 1997.

While these individually may be statistically insignificant, the networking, informal cross-outsourcing and collaboration is generating considerable activity, working to keep people in employment and off the claimant count register.

Meanwhile it is the boom in the London housing market that, Prof Ashcroft writes, “causes us most concern. We believe that the Bank of England must avoid raising interest rates on that account. With Scottish house prices hardly rising at all, it is inappropriate for the recovery to be dampened across the UK for what is clearly a local or regional issue centred on London.”

This is a critical issue that the FoA has raised and its implications for the independence referendum debate cannot be overstated. How, in any currency sharing arrangement, could Scotland enjoy any significant influence on monetary policy to ensure interest rates are at a level appropriate for Scottish economic conditions?

Logic suggests that the only way out of this conundrum is for Scotland to have a separate currency and central bank. But the Yes campaign’s favoured option is currency sharing and there is not, or not as yet, much public appetite for a separate currency.

Finally, to the key paper in the FoA Quarterly: how can we predict the winner of the 2014 World Cup? Football fans will surely appreciate this detailed economic analysis. It would not be right for me to give away too many of the easy-to-follow insights. However, here is the simple formula: Sijtsd = ß0 + ßXXij +ßZZijt + ßWWijts +ßKKijtsd + εijtsd

Where: Sijtsd is the score for the match between the team i and the team j during the year t, the semester s and the day d; ß0 is an intercept term; ßX the coefficients of the explanatory variables Xij which depend on the team i and the team j; ßZ the coefficients of the explanatory variables Zijt which depend on the team i and the team j during the year t (Population and GDP per capita differences); ßW the coefficients of the explanatory variables Wijts which depend on the team i and the team j during the year t and the semester s (Quality of players’ difference); ßK the coefficients of the explanatory variables Kijtsd which depend on the team i and the team j during the year t, the semester s and the day d, and ε (of course) is a stochastic error term.

Simple, isn’t it? Now you know who the winner is, you won’t have to watch any more games. And as for those GDP forecasts – they’re a dawdle by comparison.