Dealing with the consequences of recession

Abridged from an article by Brian Ashcroft and Fraser of Allander Institute’s Economic Commentary February 2009

“There is now almost complete certainty that not only is Scotland currently in recession but that the recession looks likely to be as severe as that in the 1980s and could even be worse.”

As a result of the unprecedented scale and increasing severity of the global and UK recession, 2009 and 2010 will be the most difficult years the Scottish economy will have encountered since WWII.

Forecasts indicate a significant downward revision in the expectations for Scottish growth over the next three years suggesting the recent UK fiscal stimulus is ‘too little too late’ and ‘relatively small compared to the US fiscal package’. Whilst we have seen a significant loosening of monetary policy, the effectiveness of this policy continues to be thwarted by the “liquidity trap”: falling asset prices force banks to hold money money as cash preventing them lending. This ‘catch 22 scenario’ strengthens the case for temporary bank nationalisation and creation of a ‘bad bank’ for toxic assets in a further attempt to unfreeze bank lending.

There will undoubtedly be significant job losses as result of the merger to form Lloyds Banking Group. These could take up to three years to work through as back office and network consolidation takes place. The radical restructuring of RBS, announcement of which is expected tomorrow, could however have an equally significant impact on employment in the Scottish financial sector.

“In November the Institute considered there was a ‘high probability’ that Scotland would go into recession in 2009. There is now almost complete certainty that not only is Scotland currently in recession but that the recession looks likely to be as severe as that in the 1980s and could even be worse.”

In November there was a ‘high probability’ that Scotland would go into recession in 2009 now it is almost a complete certainty that not only is Scotland currently in recession but that the recession looks likely to be as severe as that in the 1980s and could even be worse. The tentacles of recession are spreading throughout the economy with construction and financial service activity subject to sustained contraction, hotels & catering turning down from the first quarter of last year and real estate & business services contracting appreciably after March 2008.

Recession issues

We are in the midst of deepening world recession driven by significant falls in demand. These are the effect of “bursting the bubble” of over-priced assets such as property and shares. This burst bubble leads households to scale back demand. In addition we have High levels of household and corporate debt which also lead to a cut back in demand. This is not just a Scottish or even UK problem: World demand generally is contracting, the principal exporting countries are likely to be disproportionately hit (other things being equal). Conversely, those countries where exports count for a smaller proportion of production (e.g. the US), and where the public sector is disproportionately bigger, should do less badly in the recession. In these circumstances the impact of the recession on the UK and Scotland will not be the worst in the world as some have predicted.

The banking crisis and the apparent freezing of the credit supply function are secondary to the fall in demand. However, one should not minimise their importance. Lending has clearly dropped considerably, in part because individual countries have lost the lending previously provided by foreign banks. In the UK this amounted to about 30 percent of overall lending. Lending by UK banks has also declined as they seek to rebuild their balance sheets. The drop in the supply of credit has clearly accelerated the downturn in GDP as any monetary buffer that might have been available to provide working capital to help companies adjust more slowly to the downturn in demand has been removed.

Policy responses

Global

The scale of the global downturn suggests the US fiscal package is unlikely to compensate for the depressing effect on world trade of the US recession. As world demand contracts there are growing protectionist fears. Surplus countries may be tempted to protect their market share by adopting increasingly protectionist measures such as subsidising domestic industry. This is already beginning to happen in deficit countries such as the US and UK (e.g. the auto industry).

Financial protectionism is also on the increase as governments seek to encourage domestic banks to focus their lending on the domestic economy. Retaliation will eventually serve to destroy world trade in the medium to long-term even if there are short-term benefits to countries operating such policies. A more prolonged recession and slower long-term growth is the likely result.

The United Kingdom

The UK fiscal injection appears to be too little too late, and relatively small compared to the US stimulus package. A case can be made for a further fiscal stimulus, although rising public sector debt and foreign exchange market pressure on sterling may limit the government’s options. The significant loosening of monetary policy in the UK, which is continuing, appears to be thwarted by a ‘liquidity trap’ as asset prices fall and economic agents seek to hold cash rather than invest or spend. The case for temporary bank nationalisation in the UK and the creation of a ‘bad bank’ for toxic assets appears to grow stronger as the only effective means of unfreezing lending.

Outlook

In our central case projection, we now take the position that Scottish economy will perform a little stronger than expected UK growth. We take this view because the impacts of the systemic drop in global aggregate demand resulting from falling asset prices and financial sclerosis will be sufficient to outweigh specific sectoral outcomes such as the contraction of financial service and banking activities. Experience shows that the Scottish economy is more robust than the UK to a sharp contraction in aggregate demand as we noted in the previous Commentary. In the circumstances of the causes of the present recession the factors of relevance include: the somewhat bigger public sector and higher degree of social security payments in Scotland, while lower asset ownership e.g. houses and shares, means less exposure to asset price bubbles and bursts. On the other hand, Scotland’s relatively higher export propensity may make Scotland a little more vulnerable to a drop in global demand. But overall, we now consider that the circumstances of the recession make it more likely than we previously thought that the Scottish economy will hold up relatively better than the UK.

Employment

Table 2 outlines our net job change projections on the three cases. In the central forecast employment is forecast to decline by 14,200 in 2008, by 94,200 in 2009 and by 51,400 in 2010, a total net job loss of nearly 160,000 over the three years. This is bracketed by an anticipated net job loss of nearly 130,000 in the optimistic case and by 186,000 in the worst case

Table 2: Forecast Scottish Net Jobs Growth in Three Scenarios, 2008-2012

Net job no’s	2008	2009	2010	2011	2012
Optimistic	-14,200	-73,007	-42,400	7,923	25,089
Central	-14,200	-94,179	-51,440	3,037	14,476
Worse	-14,200	-108,984	-63,064	-6,639	10,734

Brian Ashcroft is part of the University of Strathclyde’s Fraser of Allander Institute(FAI) and provides an its Economic Commentary with the support of Pricewaterhouse Coopers LLP.

Political Comment

Scottish government

“There can be little doubt about the scale of the economic challenges facing Scotland, which highlights the importance of maintaining public sector spending to support economic recovery in the face of the serious threat posed by a proposed £1bn cut in Scotland’s budget in the two years from 2010. Cutting spending at a time when our economy is likely to need it most is absolutely the wrong approach and we will continue to make that case to the UK government in the strongest possible terms”

“But it is absolutely clear that with more powers we could do much more. The Scottish Government has no scope to borrow responsibly to boost spending and provide the further economic stimulus our economy clearly needs.” (Scottish Government)

Liberal Democrat

The Bank of England has now run out of conventional weapons, Liberal Democrat Treasury spokesman Vince Cable said today (5^th March).

"With interest rates now close to zero and the real threat of prolonged deflation and recession, the Bank's decision to start quantitative easing is understandable. Directly increasing the amount of money flowing into the economy is now the only clear option. However, the Government must be careful that this kind of radical action doesn't quickly turn deflation
into high inflation."

Conservative

"Labour’s recession has created very difficult times. The national debt is spiralling, the collective level of private savings is very low and Government like everyone else is going to have to cut its coat according to its cloth. The burden of loan now falling on the taxpayer is immense. Regulation of financial institutions has been dysfunctional and must be addressed." (Miss Goldie)

Labour

(no comment)

Lenzie.org.uk Comment

It seems a very strange idea that a recession almost universally acknowledged to be due to too much debt can be solved by increasing debt. The idea of “spending” inherently involves “borrowing” since there is no way to increase real spending without finding a source of money and since we are unable to earn that money ourselves it seems the only way to spend more is to borrow.The recession was due to the massive rise in personal, company and public debt over the last decade; Personal debt alone increased by some £1trillion which amounts to a yearly average spend equivalent to 8.5% of our total economy, much on imported luxury goods of no real benefit to the our economy.

That debt-boost, has not only stopped, but like all debt, it has to be repaid, and repaid with interest. The government can borrow more to temporarily ease the pain of less money in the economy, but that just makes the problem worse as there will be even more debt to repay when that debt has to be repaid. So, the storm has not past, we have just pushed it further into the future and at the same time made it worse.

For the last decade our economy, has been built on a mountain of debt and our GDP is considerably higher because it has been boosted by year on year increases of personal, public and company debt. That foundation can only last so long as people were prepared to borrow more and more each year, so that they would spend that added borrowing and give the economy a short-term boost at the expense of long term debt.

We are going to have to repay that debt. That will suck out of the economy far more spending than it created in the first place. That is the inevitable result of too much borrowing, irrespective of whether it is old style discredited government economic “borrow-to-bust” of new style personal borrowing to economic bust.

The truth which most people aren't yet prepared to recognise is that our economy is going to get smaller because we no longer have the boost from all that extra spending derived from extra borrowing from banks that can no longer afford to keep lending more and more. Instead of a boost, we are going to have money sucked out of the economy as we are forced to repay what we have borrowed and Government should stop trying to forestall the inevitable and certainly should not be adding to the problem by increasing that mountain of debt.

We have a simple choice: we can pretend our tottering mountain home has a firm foundation and continuing yearly piling more and more debt upon the slope only to see it washed away or we can move our economy down the mountain to a safer level of economic activity where there is a firm foundation: a sustainable economy where there is balance between saving and debt.