David Bell: Bleak time as storm clouds gather

The current economic recession delivers challenges for every sector - banks, businesses and consumers - but it could be the politicians who suffer the worst consequences

AT THE beginning of the year, I argued in these columns that the then consensus growth forecasts for 2011 were too optimistic. Unfortunately, I have been proved right.

After declining by 0.5 per cent in the last quarter of 2009, the UK economy managed to expand by only 0.5 per cent in the first quarter of 2011, implying no growth at all over that six month period. Growth in the second quarter was a paltry 0.2 per cent.

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Various special factors have been cited for the weak performance of the UK economy in the first half of 2011 - Royal Weddings, bad weather, Japanese tsunamis etc.

There was some relief in government circles that second quarter growth was at least positive, though well short of Office of Budget Responsibility predictions. The November 2010 OBR forecast for 2011 was for growth of 2.1 per cent. By July this year, this had been revised down to 1.7 per cent and few now expect this outcome to be achieved.

The prospects for a strong economic recovery have receded. The immediate explanation is the weakness in consumer demand. Relatively high price inflation at a time when wages are growing at a snail's pace have caused one of the most dramatic falls in consumers' real income ever recorded. Consumers have simply had less buying power. In combination with a significant drop in consumer confidence, the fall in real incomes is causing chaos on the high street.

Since the publication of the GDP data, the economic news has changed from depressing to dire. The downgrade of the US credit rating and the spreading eurozone contagion has further reduced UK growth prospects.

It may not be directly affected by these developments, but the UK cannot avoid the indirect negative effects on output and jobs. The probability of a double-dip recession went up several notches last week.

The government relies on the OBR growth forecast to make its own estimates of the gap between tax receipts and public sector spending. If growth is slower than predicted, then the public sector deficit will take longer to close.

Treasury forecasts now show the deficit being 0.3 per cent of GDP higher in 2011-12 and 0.6 per cent higher in 2012-13 due to the slower than anticipated recovery.

So, instead of the deficit falling to 7.6 and 5.6 per cent in 2011-12 and 2012-13, it is now expected to fall to 7.9 and 6.2 per cent in these years respectively. If growth is weaker than the OBR forecast, as most commentators now expect, the coalition government will fall well behind its plan to reduce the deficit. Prospects for 2012 are also weak. Latest OECD forecasts put the UK in the international slow lane for 2012. Ironically, it has been rated to have poorer growth prospects than the US and many of the Eurozone countries.

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The weak UK forecasts are not good news for Scotland. Changes in Scottish GDP have largely mirrored those in the UK as a whole throughout the recession, which began in the first quarter of 2008. Though Scotland is technically out of recession because it has not experienced two quarters of declining output since 2009, the level of Scotland's GDP (or Gross Value Added to be more precise) in the first quarter of 2011 was still 4.4 per cent below its peak at the beginning of 2008.

If the length of the recession is measured by the time it takes to return to previous peak output, this will probably be the longest recession in Scotland ever recorded. The National Institute of Economic and Social Research has shown that this will be the case for the UK.

By this measure, the recessions that began in 1973 and 1990 recessions each lasted three years. The 1979 recession and the Great Depression in the early 1930s both lasted four years. If the Scottish and UK economies continued to grow at the 1.8 per cent rate forecast by the OECD for 2012, GDP would take more than five years to return to its previous peak (see Figure 1). And because Scotland's recent performance has been slightly worse than the UK as a whole, its recovery would be delayed even further.

The view that this will be a protracted recession is entirely consistent with last week's IMF report which argued that the road to recovery in the UK would not be easy. It recommended that the UK government consider temporary tax cuts and further quantitative easing if the road to recovery continues to be rocky. This sounds suspiciously like a "Plan B".

For Scotland, and the UK as a whole, the key question is why the economy is taking so long to recover. The simplistic answer is that there is no longer a market for the goods and services that the Scottish economy produced in 2008.

In previous recoveries, it seems to have been less difficult to find markets to replace those that were lost in the course of the recession. This time round, there are fewer sources of growth.

The international environment is challenging for Scottish companies, partly because this recession has been more synchronised across all major developed economies than those in the past. This means that countries are more likely to go into, and out of, recession together.

At present few of our main trading partners are enjoying robust growth. Depressed consumer and government demand in the UK are also holding back expansion.

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There is now a possibility that the UK could be experiencing a more radical and negative change in its economic prospects, where lower living standards and weak growth become the norm. The explanation for this possibility has a lot to do with chickens coming home to roost. For decades, governments of many developed countries, including the UK, have avoided politically unpopular recessions by keeping interest rates low and running fiscal deficits. As a result, private and public debt grew rapidly.

Banks re-allocated this debt but in their rush for profit failed to appreciate the systemic risks of this activity. Once it became clear that the financial system was perilously close to collapse, governments had limited policy options. Banks were bailed out. Interest rates were set at historically low levels. Public finances worsened rapidly, particularly in countries with large financial sectors.

Then, because they feared the revenge of the markets, governments adopted policies, either voluntarily or under duress, to cut their deficits.

Yet if debtor countries simultaneously pursue fiscal austerity, opportunities for growth elsewhere will be limited and the world may be unwillingly propelled into another recession. Until the global imbalance between debtors and creditors is resolved, it is difficult to see how there can be a return to sustainable growth.

Clearly, any resolution will have huge political implications, with the creditor countries calling the shots. Some European countries may have to accept that Germany effectively dictates their fiscal policy, while even more surprisingly, the Chinese will be able to influence how the US sets its taxes and government spending. Major rebalancing takes time and cannot be achieved without pain.

If there is a fundamental paradigm shift where a long-run growth rate of around 2 per cent can no longer be accepted as a reasonable working assumption about Scotland, then there will be profound implications for the long-run provision of public services, such as health, education and social care. And it may lead to even more popular disenchantment with the political classes, since their ability to make short-term concessions to the voters at the expense of future generations will be much more constrained.

• David Bell is Professor of Economics at Stirling University.