Professor David Bell: Growth forecasts a little too generous

This year will be difficult for the Scottish economy. Though the economic forecasters, in their usual herd-like fashion, are focusing around a 1.7 per cent growth rate for the UK economy as a whole, the major risks are on the downside. There are a number of threats that could undermine the limited recovery that began at the end of 2009. And even if it does grow by 1.7 per cent, the Scottish economy will still produce fewer goods and services in 2011 than it did in 2007.

The local threats are numerous. UK consumer confidence fell by seven points in November to reach its lowest level since the low point of the recession in spring 2009. The UK fear of unemployment data shows that employees are increasingly worried about their jobs. In Scotland, these negative views have been reinforced by the IPSOS MORI survey released on Christmas Eve, which showed that six out of ten Scots expect economic conditions to worsen next year and fewer than one in seven intend to buy a car.

If consumers lack confidence and are worried about their future employment, they are less likely to spend. This is bad news for the retail sector, which is struggling to deal with the bad weather while trying to work out how to maintain sales now that VAT has risen to 20 per cent.

The Scottish housing market is depressed even though interest rates are at record lows. Data from the Registers of Scotland show that the number of houses changing hands from July-September 2010 was less than half that in the equivalent period of 2007. This week the Council of Mortgage Lenders predicted that net mortgage lending will hit a 30-year low in 2011. It peaked at 100 billion in 2006. The CML expects it to fall to just 6 billion in 2011. Consumers being charged low interest rates are paying back their mortgages as fast as they can. But first-time buyers are finding it difficult to prise loans on reasonable terms from banks and building societies. Low volumes are bad news for the building trade and for professionals involved in buying and selling houses. They also hit furniture and DIY businesses. Stamp duty falls when the number of house sales falls. The June 2010 Budget forecast that stamp duty would rise from 5.8 billion in 2010-11 to 7.1 billion in 2011-12 - a 22 per cent rise. If the Scottish experience is typical of the UK as a whole, this forecast looks wildly optimistic.

Another key local factor for the 2011 outlook is the impending cut in public spending.

Next financial year, the Scottish Government will have 1.3 billion less to spend than it had in 2010-11. Most of this money would have been spent in Scotland. Much of the pain of public spending cuts will fall on the private sector, since in the draft 2011-12 budget, 56 per cent of the cuts come from capital rather than current spending. And a large proportion of public capital spending is used to buy roads, schools and hospitals supplied by the private sector.Public spending will also fall on programmes and projects that the Scottish Government does not pay for. Though the process of cutting welfare spending will only start in 2011, by 2014-15, around a further 1.7 billion will be taken out of public spending in Scotland. The effects will be spread right across Scotland. But cuts in defence spending will be much more concentrated. So far the obvious example is the closure of Kinloss and its effect on the Moray economy.

The public sector cuts will reduce demand for goods and services in Scotland by more than 1 per cent, given that Scottish GDP is around 100 billion. If there is to be real growth in the Scottish economy, then other sources of demand will have to be found to replace the fall in public sector purchases. If consumption and investment demand remain weak, exports are the only remaining potential source of significant growth.

And there are some glimmers of hope in key export sectors. Scottish production industries grew by 2.5 per cent in the second quarter of 2010 though from a low base: production output in mid-2010 was 7.2 per cent below its pre-recession level. The most resilient production industries have been food and drink, energy production and refining. Engineering is a very mixed bag. Mechanical engineering has been growing, but Scottish output of electrical engineering products has almost halved since 1999.

Production growth has come despite the difficulties that companies have in finding credit. The Bank of England showed recently that a large proportion of the reduction in bank lending since the beginning of the recession is due to the tightening of credit conditions rather than weak demand for credit. This analysis firmly refuted the commercial banks' argument that their lack of lending was entirely due to a lack of demand for loans.

Loans are more risky during a recession and the demand for credit will be weaker. But even allowing for these influences, the Bank found that companies have had more difficulty raising cash from the commercial banks since 2007. Banks, acting in their own self-interest, want to rebuild their capital to increase their resilience against bad debts. This means reducing lending to businesses and individuals. Unfortunately, when all banks follow this strategy, the combined effect is to weaken the demand for goods and services and so make bad debts more likely. So the whole process may implode. If we don't hit another financial Armageddon, perhaps the Banking Commission can inject some urgency into the case for more competition in the banking industry and increase the credit options for Scottish businesses.

The contraction of credit makes it more difficult to sell to local consumers and domestic businesses. They don't have the credit to make the purchase. Hence the incentive to switch to foreign markets. Scottish exporters have the advantage of the devaluation of the pound against other major currencies since 2008. Irish exporters looking to exploit European markets do not have this good fortune.

The experience of these industries before, during and after the recession has some very important lessons for the future of the Scottish economy in 2011 and beyond. First, it is clear that many firms have left Scottish shores or not even approached them because the combination of costs and productivity that we offer can easily be bettered elsewhere - particularly in Asia. In the last decade, the tectonic plates of the world economy have shifted east. Europe now significantly lags behind Asia in economic dynamism and investment opportunities.

The financial crisis led to a serious contraction in world trade. Asian exports fell by 26 per cent between the first quarter of 2008 and the first quarter of 2009. European exports declined by 34 per cent. The European economies have still not recovered their pre-recession level. But in Asia, exports have risen by a staggering 63 per cent from the beginning of 2009 to the third quarter of 2010. The contrast in the current performance of the European and Asian economies is vast. European economies have lost their attraction to investors. For example, competition from Asia is mainly responsible for the substantial decline of Scotland's electronic and electrical engineering industries.

The Scottish Government recently published estimates of the size of Scotland's export markets in 2008. There was no Asian country in the top 10: but Ireland, Spain and Italy were in fifth, sixth and eighth places respectively. Given the eurozone's woes, none of these is likely to be a good prospect for export growth in 2011.

So 2011 is likely to be a difficult year for the Scottish economy, involving further painful rebalancing away from credit-sustained private consumption and public spending. Growth of 1.7 per cent would be a considerable achievement. And if it is to facilitate this outcome and therefore meet its own primary objective of maximising sustainable economic growth, the Scottish Government really has to focus its activity where it can assist this rebalancing - particularly in facilitating Scotland's trade links with Asia. l David Bell is Professor of Economics at Stirling University