Brian Ashcroft: Scotland must not rely on the confidence fairy

IN LAST Friday’s Scotsman, George Kerevan pays me the compliment of discussing my views on the current economic situation. I welcome his intervention because there is a need for a vigorous public debate about, and action to address, the current difficulties facing all the major economies, including the UK and Scotland.

Mr Kerevan says there is a broad agreement on the need for government action to prevent the UK sinking into recession again. The real debate, he suggests, is about what should be done. He claims to accept that the level of demand for goods and services in the economy needs to be raised. Then he argues that this can be achieved by an increase in the money stock through more quantitative easing, increased capital investment, targeted VAT cuts, and by the devolution of corporation tax to Scotland, which will promote business confidence. He cites the evidence of the good recent performance of the Scottish labour market, saying that was a result of the policy actions of the Scottish Government in bringing forward capital expenditure, and more confident Scottish companies reassured by a pro-business Scottish Government, compared with a pro-austerity UK government.

It is a nice story but, sadly, it doesn’t hang together.

First, while George Kerevan claims to be on the side of those who advocate government action, at root much of his argument has similar intellectual underpinnings to the views of George Osborne and the UK coalition government. This is because both rely on what Paul Krugman calls the “confidence fairy” to justify their positions. For Mr Osborne, fiscal austerity promotes business and financial market confidence to secure recovery and growth. For Mr Kerevan, it is political leadership and the actions of the Scottish Government that are promoting, or would promote, confidence and recovery in the Scottish economy.

Low consumer and business confidence is the outcome, not the root cause, of our present economic problems. There has to be a reason for low confidence, and the real reason is a lack of effective demand for goods and services. So households are not confident enough to raise spending because they are trying to save more to remove a debt overhang, and because they fear for their jobs and future incomes. Firms are not investing and hiring much labour because the demand for their goods and services is weak and is expected to continue to be weak for the foreseeable future. Being impressed with the policies of Alex Salmond and the Scottish Government is neither necessary nor sufficient to get the “confidence fairy” to fly over Scottish consumers and businesses – not to mention the people outside Scotland who buy Scottish exports.

The promotion and realisation of more demand for goods and services are the key to raising consumer and business confidence in present circumstances.

So how is that to be done?

The test is whether a policy measure is likely to have the necessary effect in raising demand.

Further quantitative easing (QE) would be welcome but there are technical reasons why more QE at this time may not be so effective. Put simply, an expansion of the money stock has an impact on the demand for goods and services via lower interest rates and higher prices of (financial) assets. But nominal interest rates are now effectively zero and real interest rates negative. People expect rates to rise at some point, hence the increased money stock is likely to be held – technically, a “liquidity trap”. This is what has happened with the first round of QE: the base money stock has risen but not the broader money supply including bank deposits. Banks sit on their cash balances and medium to large firms do too, failing to invest.

So, we need a fiscal stimulus: a mix of tax cuts and expenditure increases as Barack Obama proposed for the US last week. And it should be of sufficient scale to make a difference within a credible fiscal framework that balances the books in the medium to long term. The opinion in Britain outside the coalition, including opposition parties, appears to accept this, as does the Scottish Government with its so-called Plan Mac-B.

Ideally, the balance of the economic argument would favour capital expenditure on infrastructure, because it boosts the supply potential of the economy as well as demand. But that requires “shovel-ready” projects that can stimulate demand now. Some projects can meet that requirement such as housing projects, but they are hard to find. Which leaves us with tax cuts. Here I have some sympathy with George Kerevan’s argument for targeted VAT cuts, but remember the object is to find the best way to raise aggregate demand. On that basis a general cut might be preferred. Sure, some of the increased demand will leak out in imports, but I would guess less so now that sterling is more than 20 per cent below its 2007 level.

The rest of Mr Kerevan’s suggestions simply invoke the “confidence fairy” and should not detain us further.

But what about those recent good Scottish labour market figures?

The Scottish labour market is still weak both absolutely and relative to the UK, as is output and production, which drives the demand for jobs. Total Scottish employment is about 2 per cent below its pre-recession peak, and the private sector employment-working population ratio is still 4 per cent below that pre-recession peak nearly four years after the start of the recession.

The Scottish Government’s decision to front-load capital investment may have helped promote job creation in Scotland recently but this is unlikely to be sustained as public spending cuts start to bite.

In the absence of the adoption of a UK Plan B, if Scottish jobs growth continues to outperform the UK then Mr Kerevan’s “confidence fairy” will have done her work. I remain sceptical. Future data should help clarify who between us is correct.

l Brian Ashcroft is emeritus professor of economics at Strathclyde University