David Bell: Stunted growth, if any

To SAY that 2012 will be a difficult year for the Scottish economy is stating the glaringly obvious. Professional forecasters concur. Output in Scotland and in the UK as a whole have moved closely together since the beginning of the recession. There are no compelling reasons to expect divergence in 2012. The average City forecast for UK output growth in 2012 is 0.6 per cent growth. If this is accurate, then Scotland is likely to experience another year of anaemic growth.

At the beginning of 2011, the City was suffused with misplaced optimism. The average forecast made in December 2010 was that the UK economy would grow by 1.7 per cent in 2011. I argued in these columns that growth of 1.7 per cent would be a considerable achievement. The City forecasters have now downgraded their expectations for the 2011 out-turn to a more realistic 0.9 per cent.

Certainly there have been some unexpected, but perhaps not unforeseen, economic events during 2011. Top of the list is the implosion of the eurozone. Events in Europe this year illustrate what the macro-economist Olivier Blanchard has described as the “schizophrenia” of the market view of fiscal consolidation and growth. Financial markets force governments into adopting austerity packages by forcing up their financing costs and then they react negatively when these same policies lead, completely predictably, to lower growth.

Moody’s, the credit rating agency, recently threatened the UK with a downgrade of its debt due to its poor growth performance. But the poor growth performance was largely the result of the austerity measures adopted by the UK government. These were triggered by concerns that the credit rating agencies would downgrade the UK due to its large fiscal deficit, causing interest rates to rise.

The effects of downgrades and loss of confidence is haunting continental Europe. Last week, Spain was paying 5.5 per cent on ten-year debt, Italy 7 per cent, Ireland 8.5 per cent, Portugal 13.1 per cent and Greece 34.2 per cent. These are not sustainable rates, even if the OECD growth forecasts for these countries are accurate.

If the euro collapses, these forecasts are irrelevant. Should countries as large as Spain or Italy default on their debts, then the whole European banking system is in jeopardy. Depositors will be desperate to find havens for their savings. Already there is evidence that companies and wealthy individuals from Greece are moving money abroad because they have lost confidence in the Greek banks. If the same happens in Italy and Spain, then European capital markets will be in chaos.

In these extreme circumstances, the UK may be seen as a haven for savings. This would cause a rapid appreciation of the pound, further reducing the chance of economic recovery.

But even if the worst-case euro collapse does not happen, the OECD view is clearly that the European economy will endure a difficult 2012. The Scottish economy will not be immune from continental difficulties. Spain, Ireland and Italy are Scotland’s seventh, eighth and ninth-largest export markets. Only the US, our largest market, is likely to approach a “normal” growth rate during 2012, according to the OECD.

Yet the December PMI index from the Bank of Scotland shows that the private sector in Scotland has been maintaining output levels. But work has mostly been focused on existing orders. Consistent with the difficulties in the external environment, new orders fell for the third month running. The declines were spread across the domestic and international markets.

Perceptions have a real influence on how the economy performs. Political rhetoric that has focused on talking down the UK economy has played a part in weakening confidence, which in turn has reduced the chance of any substantial real recovery in demand driven by the private sector. When the common perception is that the UK economy is in a mess, it is no surprise that the private sector has not expanded to take up the slack in the economy left by the effects of austerity measures on the public sector.

The negative sentiment comes through very clearly in the latest IPSOS-MORI poll for Scotland, which showed that the Scottish public are very pessimistic about economic prospects for 2012. And though Scots are slightly less pessimistic than those in the rest of the UK, confidence has declined significantly since April 2011. Pessimism about economic prospects has led many consumers to cut back. Plans for major purchases, such as houses or cars, remain weak.

The faintness of the housing market has been one of the most obvious signs of recession. “For sale” signs have been in place for so long that some must surely have taken root. And the phrase “offers over” seems to have disappeared from the estate agent’s vocabulary. The number of houses traded has collapsed. Before the recession, around 35,000 homes were being sold in Scotland each quarter. Since the beginning of 2009, quarterly sales have averaged just 18,200.

Downward pressure on house prices will continue through 2012, and will be reinforced by banks and building societies tightening their lending regulations. The process of bringing house prices down to a more realistic relationship with incomes is undoubtedly painful, but may be necessary to bring about some recovery in the volume of houses bought and sold. A becalmed housing market does the economy no favours. For example, workers who want to take up new jobs have to be able to move and that often means selling and buying in the housing market.

Overall price inflation will fall sharply in 2012. The increase in VAT introduced last January will drop out of the inflation figures, as will some of the recent fuel increases. Bank of England Governor Mervyn King may stop having to write letters to the Chancellor each month to apologise for inflation being above 3 per cent. This means that the drop in real living standards will slow down in 2012. But there has already been a significant fall in the average worker’s buying power. The GMB union estimates that real earnings in Scotland fell by 4.1 per cent between 2007 and 2011, less than the 5.9 per cent recorded for the UK as a whole.

This fall in real earnings is broadly consistent with the decline in the real output of the Scottish economy of 3.8 per cent between the second quarter of 2007 and Q2 2011. Yet this may underestimate the real loss in output. If growth had stayed on the trend set between 1998 and 2007, Scotland’s output would have been 9.7 per cent higher by the middle of 2011.

Thus, had there been no financial crisis and no recession, Scottish real income per head would now be almost 10 per cent higher. If the growth trends established in 2010 and 2011 are continued through 2012, output will be 13 per cent below where it would have been had pre-2007 trends continued.

Yet perhaps some of the pre-2008 growth was an illusion, based on the excessive expansion of credit and risk. This is certainly the view of many Irish economists about the behaviour of the Irish economy between 2000 and 2007. Indeed, this argument may apply to many other European economies, with Germany standing out as the clear exception.

Scotland’s annual growth rate between 1998 and 2007 was 2.3 per cent, close to that of the UK as a whole. Yet this may be an overestimate of the long-run growth potential of Scotland, the UK and many European economies. Many economists, but few European politicians, are discussing the possibility that for their economies, growth can no longer be assured. Increased resource prices, regulation, high tax rates and low productivity growth will make it increasingly difficult to substantially increase living standards in the face of intense competition, particularly from Asia.

For politicians, the problem is that many of their prized spending plans are based on assumptions of economic growth of 2 per cent or above. Scotland is not immune from such pressures.

• David Bell is professor of economics at Stirling University