Scottish Government

The Council of Economic Advisers has been created to advise the First Minister on how to increase Scotland's sustainable economic growth rate. The fifth meeting of the Council will take place on 16 January, 2009.

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MINUTES OF THE FOURTH MEETING - 3RD OCTOBER 2008 - DUMFRIES HOUSE, CUMNOCK

Introductions, minutes & actions arising

1. The Chair extended a warm welcome to all members of the Council to the fourth meeting.

2. The Chair referred members to the minutes and matters arising from the third meeting. The Chair invited Dr Andrew Goudie, the Chief Economic Adviser to the Scottish Government, to update the Council on the Scottish Government's response to the Council's recommendation to commission an external assessment of the costs of alternative energy options. Dr Goudie noted that the Scottish Government has endorsed the Council's recommendation and that some initial scoping work is currently being undertaken. It was agreed that a sub-group of the Council would meet in November to agree the specification for the main study.

3. The Council indicated that they were content with the minutes and other matters arising from the third meeting.

HBOS-Lloyds TSB takeover

4. The First Minister began by setting out the Scottish Government's view on the action that needs to be taken in response to the global financial crisis. He then informed the Council of the action that the Scottish Government has taken in response to the proposed take-over of HBOS by Lloyds-TSB and the further action it intends to take.

5. The Scottish Government's view on the global financial crisis is that action is required to get ahead of events rather than simply responding to them. Further, that this action needs to be co-ordinated internationally and needs to be far more radical than what we have seen to date. The First Minister outlined the different types of action which could be taken in response to the latest developments and invited the Council's views.

6. The First Minister then turned to the proposed take-over of HBOS by Lloyds-TSB and described the potential impact on the Scottish economy. He noted that the merger is not guaranteed, that key decisions have yet to be taken on the take-over and that the lines of communication between the Scottish Government and Lloyds-TSB/HBOS are very much open. If the merger goes ahead, the Scottish Government's key aim is to retain decision making functions in Scotland and secure Scottish jobs. The First Minister set out the strong business case that has been sent, and which he will present, to Lloyds TSB for retaining headquarter functions in Scotland. The First Minister welcomed the Council's views/advice on the 'Case for Scotland'.

7. The Council emphasised the tremendous strengths Scotland has in the finance and wealth management sector and the compelling business argument to locate key decision making elements of the merged organisation in Scotland. The Council supported the Government-led business case that has been put to Lloyds-TSB and HBOS negotiating teams and the importance of getting the best possible outcome for Scotland if the merger does go ahead

8. The Council agreed to issue a statement to this effect.

Update on the Scottish economy

9. The Chair invited Dr Andrew Goudie to provide an update on the Scottish economy.

10. Dr Goudie reminded the Council that when it has last met in June, he had considered the resilience of the Scottish economy within the context of the credit crunch and the sharp increases in commodity prices. On balance, while there were clear risks and expectations that some indicators would only show a lagged response to the global slow-down, there were clear signs of resilience, for example: growth compared to the rest of the UK; the labour market; retail sales; and the housing market. However, there were also signs of weakness in terms of emerging business and consumer confidence and emerging business output and government expenditure.

11. Since then the situation has deteriorated. There has been the fall-out from events in the US housing market, the drying up of liquidity in money markets, the collapse and major restructuring of some of the largest financial sector companies, and pervasive fear across the financial sector.

12. Dr Goudie reviewed recent trends, key indicators and evidence from business surveys to assess:

• how the Scottish economy has withstood the past few months;

• what evidence there is that the financial crisis is impacting on the real economy;

• how we might expect Scotland to fare in the coming months.

13. Dr Goudie's assessment concluded that:

• the Scottish economy is less resilient than it was;

• financial turbulence is spilling over into the real economy;

• current performance against key indicators remain strong - even if recent trends and expectations are weaker.

Scotland's economy is less resilient than it was

14. Dr Goudie noted there is increasing evidence that the global slowdown and credit crisis have weakened the performance of the Scottish economy. Several indicators suggest a softening of performance in both output and the labour market and the prospect is of more significant weakening over the rest of 2008 and 2009. For example, although the Scottish economy grew in the first quarter of 2008, this was at a slower rate than at the end of 2007. More recently, Scottish manufacturing export sales remained broadly flat in the second quarter of 2008, partly due to weaker external demand in the global economy. Over the past year, there has also been a reduction in the number of people in employment of 19,000, which has resulted in both a rise in unemployment and in the number of people who have left the labour market (i.e. become economically inactive).

15. Dr Goudie noted that although the latest independent forecasts for Scottish GDP growth predict an average growth of 1.7% in 2008 and 1.6% in 2009, these forecasts are likely to be revised down in line with more recent UK growth forecasts (down to 1.2% in 2008 and 0.3% in 2009).

Financial turbulence has spilled over into the real economy

16. Dr Goudie noted that there are signs that the financial turbulence is spilling over into the real economy and mounting recurring anecdotal evidence to support that view. Evidence from backward-looking business surveys, for example, report that the growth in output from Scottish businesses slowed significantly in Q2 2008, indicating that GDP growth may be weaker in Q2 2008. Similarly, for Q3 2008, the surveys report a further deterioration in conditions, with some reporting a decline in the output of Scottish firms. Furthermore, the latest forward-looking business surveys indicate that business confidence in Scotland continues to fall due to uncertainty over the current global economic slowdown and the impact of the international financial crisis. This suggests that growth could continue to slow in the final quarter of 2008 and into 2009.

17. Dr Goudie noted that the Scottish housing sector has experienced a significant drop in the level of activity due to the reduction in the availability of mortgages. This slowing in the Scottish housing sector has had a knock-on impact on Scottish house builders, with a number of construction companies announcing plans to reduce their workforce. Recent evidence also suggests that the availability of credit for businesses has reduced substantially at the same time that the cost of credit has increased. This will, of course, vary on a case by case (and sector by sector) basis. For households, credit availability generally has become more restrictive. Consumer confidence about future conditions has also weakened considerably in recent months.

Current performance against the key indicators remains strong - even if recent trends and expectations are weaker

18. However, Dr Goudie also pointed out that current performance against key indicators remain strong, for example:

• Scottish GDP continued to grow in the first quarter of 2008 (data for Q2 2008 GDP will be published on 22nd October);

• Despite softening over the last year, the overall performance of the Scottish labour market remains relatively strong. The employment rate remains close to its historic high and the unemployment rate is still significantly below the UK and other advanced economies;

• Scottish retail sales data suggest that sales have stood up well in contrast to the UK, although there are concerns over the data quality of this series;

• While the latest data are mixed, in general, Scottish house prices have remained more resilient than for the UK as a whole. Recent data, however, indicate that house prices in Scotland have fallen in the past year.

19. There should not, therefore, be unreserved pessimism about the performance of the Scottish economy.

20. The Council supported the view that the financial crisis is spilling over into the real economy. The paralysis in the financial sector means that loans are not available to develop businesses and even large successful businesses that have access to strong revenue flows are having to put more complex funding arrangements in place to raise the necessary capital, and are paying significantly more for it. The Council noted too that as unemployment typically lags changes in output by 1-2 years, further weakening in the employment position is to be expected.

21. The Council stressed that even when the financial situation stabilises, credit for businesses will not be available on the same scale and in the same way as it has been over the last few years. In recent months businesses have had to give up increased equity in return for funding - this is unlikely to change and businesses will need to develop more innovative ways of accessing funding. It was noted that this is already evident in the oil industry cluster where those that have borrowed substantial amounts in the past are unwilling to take on more debt, and alongside banks being unwilling to lend, are looking at unorthodox equity sources to get good projects up and running. The Council also stressed that the cost of private equity (which is still the most expensive form of debt) needs to come down.

22. The Council also pointed out that while there are emerging signs of fragility in some sectors, there are also other sectors in which performance remains robust, notably on the energy side with prospects in the north-east still strong.

Addressing Economic Inactivity in Scotland

23. The Chair invited the CEA leads on this topic to set out their views on the action that should be taken to reduce economic inactivity in Scotland.

24. The CEA leads started by setting out the background. Within the Government Economic Strategy (GES) there are seven Purpose targets. This work has focused on two targets - Participation and Cohesion - both of which are central to achieving the Scottish Government's Purpose of increasing sustainable economic growth. Participation is critical for economic growth by increasing the workforce, raising consumption and reducing the economic and social costs of worklessness. Cohesion is important if the benefits and opportunities of growth are to be shared across the country. It is also a key factor in growth: improving participation rates in the worst-performing areas of Scotland can boost overall economic growth (particularly in the case of Glasgow City). Further, it can free up public sector resources used in addressing deprivation for investment in other parts of the economy, with savings to be made directly in the welfare budget as well as indirectly in health and other budgets.

25. The CEA leads examined Scotland's performance in relation to these targets - which is broadly positive - and identified the challenges that would be involved in ensuring these targets would be met by 2017. They also identified the key drivers of higher participation rates as this is key to understanding what can be done to improve participation and cohesion and commented on the effectiveness of current policy approaches. Finally, the CEA leads presented various propositions which in their view could help ensure that Scotland achieves its Participation and Cohesion targets. These included: measures to facilitate older-age individuals to remain in employment for longer; ensuring young people receive work experience and adequate support for early and sustainable entry into the workforce; reducing the risk, and increasing the attractiveness, of employment to those on benefits; establishing more structured and pro-active engagement with employers; developing a more enterprising, effective third sector; extending the partnership approach for local delivery of skills policy, improving data sharing between employability partners; increasing the focus of policy and resources at national and local level on raising Glasgow's employment rate; and, exploring opportunities for removing the inefficiencies in the distribution of responsibilities for skills and benefits policies.

26. The Council discussed the various propositions that had been presented. The Council agreed that further refinement of flexible local delivery would be key to meeting the Government's targets in this area. This could include further devolving the activity undertaken by Jobcentre Plus employment services to local partnerships, or at the very least doing more to ensure local priorities are directly and formally reflected in decisions taken by Jobcentre Plus for the Scottish operation of its services. It was also agreed that improving data sharing between public bodies is an obvious area where greater action could have a significant and quick impact. There is a need to find better ways of ensuring that local partnerships are able to access the information they need to effectively help people into work. The Council also stressed the need to get the civic model right to ensure that there is a flexible and joined up infrastructure to support people into employment. There was also general agreement that there is significant scope for improving participation rates of older-age individuals. It was suggested that more action could be taken to strengthen participation rates in this age group by both the UK and Scottish Governments.

27. The Council agreed that the Scottish Government should be asked to consider all the propositions and identified four that should be given particular priority:

• extending the partnership approach for local delivery of skills policy;

• improve data sharing between employability partners;

• exploring opportunities for removing the inefficiencies in the distribution of responsibilities for skills and benefits policies;

• facilitating older-age individuals to remain in employment for longer.

Raising Productivity Levels in Scotland

28. The Chair invited the CEA lead to update the Council on the work that he has been undertaking on productivity.

29. The CEA lead started with the Scottish Government's Purpose of increasing sustainable economic growth. He noted that higher rates of growth can only be sustained if the working population grows, or if productivity increases, or both. Given the quite striking figures on population growth which suggest that the working age population will shrink over the next 30 years, delivery of the Government's Purpose will depend on securing increases in productivity. The CEA lead noted that over the last few months, he has reviewed literature on the sources of, and the policies necessary to achieve, increased productivity and has considered how what we know can be used to help deliver the Scottish Government's targets, including productivity.

30. The CEA lead ran through the different arguments for focusing on productivity growth -conventional and less conventional - and focused on those that are particularly important for a small economy like Scotland. The CEA lead noted that these arguments suggest a strategy of trying to increase the average level of productivity in the economy through training and skills and in particular increasing the share of high productivity firms/industries in the economy. It was noted that Scotland has specialised in lower productivity sectors relative to the UK, with more industries being less productive and fewer being more productive. Further, that Scotland appears to have been less successful in allocating labour and capital to where they can be used most productively.

31. The CEA lead noted that there is an important distinction to be made between labour productivity and capital productivity. Labour productivity in Scotland is 3% lower than in the rest of the UK (and falling) while wages are 4% lower. That means unit labour costs are 1% lower than in the rest of the UK, and, if all else were equal, output should be growing faster in Scotland. But it is not: national output growth has been between 0.5%-1% points slower on average since 1976. All other things, therefore, are not equal and the most plausible explanation is that capital productivity is significantly lower in Scotland (if we take capital and total factor productivity to include the contributions of transport, infrastructure, R&D and organisational methods).

32. Additional analysis of labour productivity in England and Scotland shows Scots are working harder per hour but are less productive. This suggest that Scottish workforce is substituting a greater labour input for less productive capital. What is holding Scotland back therefore is low capital productivity, or, with so many firms operating in Scotland that are headquartered elsewhere, a branch office problem.

33. The CEA lead then considered the lessons which Scotland could learn from the experience of other countries, including enhancing labour productivity by raising the productivity of the capital they work with. This comes from increasing the productivity of IT equipment and its production; and then, more importantly, from learning how to use it effectively. The largest improvements, however, have come from rises in total factor productivity resulting from innovations and investment in how to (re-)organise production and/or management. This highlights the need to solve the branch office problem.

34. The Council agreed the importance of increasing the general level of productivity in the workforce and increasing the share of high productivity firms/industries in national output. One way of doing that is to encourage the development of certain key sectors and to promote clusters of industries so as to exploit their external economies of scale and specialised services. The Council also agreed that there is a need to focus on improving capital productivity and total factor productivity. Here policies to encourage smaller firms, non-traditional firms, firms with a higher proportion of their activities in Scotland, as well as those that help extend external trade and foreign investment in Scottish firms, or imply some devolution in the labour markets, would be appropriate.

35. The Council asked the Scottish Government to consider:

• Increasing the general level of productivity in the workforce, especially through skills and training, and increasing the share of high productivity firms and industries in national output;

• Encouraging the development of key industries and sectors, and of facilitating the formation of clusters with external economies of scale, critical mass for skills and specialized industries;

• Improving capital productivity and total factor productivity, alongside labour productivity;

• Improving capital productivity, including finding ways to reduce the branch office problem, and providing incentives for firms to reorganise their production methods, management techniques, and to introduce technical and managerial innovations in their plants in Scotland - not just on average across the UK;

• Using productivity as a means of lowering unit costs in production, and hence as a vehicle to induce firms to set up or extend their activities in Scotland. It should explore: lower business taxes and rates; improved planning procedures; better infrastructure and communications; specialised services; and ways of increasing flexibility in labour market practices as the means to do this;

• Increasing productivity growth through generalised measures, for example, by encouraging small or non-traditional firms, and by providing incentives for firms to extend their share of external trade or to increase the participation of foreign investment.

Financing Public Sector Infrastructure

36. The Chairman noted that the CEA lead on this topic has begun a review of the economic role, current condition and means of provision of infrastructure in Scotland. He invited the CEA lead to present his key findings.

37. The CEA lead structured his presentation around five questions:

• what has happened to infrastructure investment in recent decades?

• what have we learnt about successful and unsuccessful management of infrastructure projects?

• what is and should be the fiscal framework for infrastructure projects in Scotland and the UK?

• how should infrastructure projects be financed?

• what should be the governance structure of hybrid institutions?

38. The CEA lead noted that spending on infrastructure in the UK as a share of GDP has declined substantially from 1970 to 2000 (from almost 10% of GDP to 1.7%), with a modest increase thereafter to 2.5%. The Scottish position is believed to be similar. The CEA lead identified those sectors where infrastructure investment has declined, stabilised or increased as a share of GDP since 1970. He drew particular attention to the large decline in social housing investment in Scotland where local authority construction has fallen to negligible levels and the large increase in spending on railways.

39. The CEA lead highlighted the fact that the cost of many public sector infrastructure projects in Scotland have exceeded estimates by significant amounts and set out the problems of managing infrastructure projects that are likely to have contributed to cost escalation. The Council agreed that the development of project management skills within the public sector is critical to the effective provision and operation of Scotland's infrastructure.

40. The CEA lead then turned to consider the fiscal framework within which the provision of infrastructure takes place. He first considered the UK position as the decisions of the Scottish Government need to be made within the funding arrangements of the UK as a whole and then the Scottish position and the specific provisions applicable to Scotland under existing constitutional settlement. The Council discussed the fact that in essence the broad elements of the Scottish framework were not changed by devolution and in matters such as provision of capital spending and VAT the defining principles are similar to those applied in English government departments. The Council agreed that whatever view is taken of the overall constitutional settlement, that accounting principles in Scottish public finances need to be reviewed in the light of experience since devolution.

41. The discussion then turned to PFI and alternative methods of financing public sector infrastructure. While the Council recognised that PFI has funded projects which otherwise could not have been funded, the Council was concerned by the ongoing costs of these schemes and the severe constraints that these costs will put on future spending. The Council welcomed the proposal to explore a wider range of funding options through the Scottish Futures Trust.

42. The Council noted that the current cost of long term government borrowing in real terms is probably at levels lower than ever previously experienced in modern economic history. The Council agreed that while current conditions create many problems, they also create a favourable environment for increasing spending on Scotland's infrastructure.

43. The Council asked the Scottish Government to consider the following:

• The Council believes there is a need to raise the overall level of infrastructure spending within Scotland and to review the state of Scotland's infrastructure (including those elements of it which are owned or operated by private companies) within a single comprehensive framework.

• The Council believes that government borrowing of a conventional kind offers value for money and transparency. The Scottish Government should, wherever possible, avoid investments with significant ongoing costs and should make clear the implications of current decisions for future spending.

• The Scottish Government should secure independent monitoring of this reporting and of its overall fiscal stance.

• The Scottish Government should pursue, with the UK government, revisions to the current fiscal arrangements which would enable it to plan efficiently the appropriate balance between current and capital expenditure, and to meet Scotland's overall infrastructure needs.

• The Scottish Government should seek to develop its expertise in the management of infrastructure projects. The development of such expertise should be accompanied by better project assessment and value for money auditing.

First Annual Report

44. The Chairman led a discussion of the Council's first Annual Report and concluded by noting that the Report would be published in late November/early December.

Next Meeting

45. The next meeting will take place on Friday 16th January, 2009.

The following members of the Council were present:

First Minister
Sir George Mathewson (Chairman)
Crawford Beveridge
Frances Cairncross
Professor Andrew Hughes Hallett
Professor John Kay
Professor Alex Kemp
Professor Finn Kydland
Sir James Mirrless
Jim McColl
Lord Smith (joined the morning session by audio conference)

Apologies: Professor Frances Ruane

Also present:

John Swinney, Cabinet Secretary for Finance and Sustainable Growth
Dr Andrew Goudie, DG Economy and Chief Economic Adviser, Scottish Government
Fiona Robertson, Head of Economic Strategy Directorate, Scottish Government
Dr Jennifer Steedman, Economic Strategy Directorate, Scottish Government
Lucy Proud, Economic Strategy Directorate, Scottish Government
David Bishop, Economic Strategy Directorate, Scottish Government
Stephen Noon, Senior Policy Adviser, Scottish Government
Jennifer Dempsie, Senior Policy Adviser, Scottish Government
Maureen Rooney, Assistant Private Secretary to the First Minister, Scottish Government