Reasons to be cheerful over the health of our economy

THE Scottish economy has had two good years, with average annual growth of about +2.4 per cent in 2006 and 2007, well above the historic average. Most economists expect a slowdown over the next few years and last year I predicted +2.2 per cent growth in 2008, falling to +2 per cent in 2010.

The recent housing mortgage crises in the United States and the UK, however, have spread panic and gloom, with some commentators predicting a recession. Are they justified? I do not believe so, at least on present evidence. It will be a few months before there is real evidence of a substantial downturn, if that is occurring, and I remain optimistic.

I seem to be in a minority, however. The Federal Reserve Bank in the US has slashed the base interest rate there from 5 to 2.25 per cent in a desperate attempt to stimulate the economy and regain confidence in the financial markets.

Bear Stearns, one of the most prestigious banks on Wall Street, has just been rescued from bankruptcy and we have a similar situation here with Northern Rock. The subprime losses in the US have been estimated at an incredible $300 billion (£151bn) and in the UK at £20bn.

I am bemused at how banks and other financial institutions could lose such enormous sums over solid assets such as mortgages, particularly when there are few signs of house prices collapsing. Nevertheless, the Bank of England and the Fed are clearly very worried. There are few signs of a slump in Scotland, however.

Indeed, some of the latest economic statistics are surprisingly positive, notably unemployment, which is at a 32-year low.

Consumer confidence is vital. If consumers reduce spending, the economy will inevitably slow down because more than 70 per cent of our economic output now comes from the service sector. However, the latest statistics from the Scottish Retail Consortium show like-for-like retail sales up 2.5 per cent in February. That is just above the rate of inflation but there are no signs – yet – of a sharp fall in consumer spending.

The financial services industry is very important in Scotland, because of the presence of Royal Bank of Scotland, HBOS, Scottish Widows, Aberdeen Asset Management and many others, so it is understandable that some people believe that our economy is vulnerable to the financial crises. The industry has achieved very high growth in recent years, with average annual growth of more than 6 per cent.

I had already forecast a slowdown to +4 per cent in 2008 and that figure might have to be revised further downwards. There were wild rumours last week that HBOS had asked the Bank of England for emergency funds, but they proved unfounded.

RBS has made provisions for subprime losses, but they are very small in the context of the bank's overall profitability. Most of the industry in Scotland seems unaffected.

Another important factor is the large size of the public sector and the high level of public spending, which gives some protection against downturns in the private sector.

Public-sector spending in Scotland must – and should – fall in real terms over the next few years, but the rate of decline should not cause serious problems and certainly not in 2008.

I am concerned, however, about the implications for the housebuilding industry. We have had a very low level of building over the past decade, averaging just 25,000 new homes per year. The government and Homes for Scotland believe the level needs to be raised to more than 30,000.

There were recent signs of a modest increase in new building, but I fear that the crises in the mortgage markets will reverse that. It is now more difficult to obtain mortgages because virtually all lenders have become more cautious. Thus there may well be a significant downturn in the housebuilding industry, particularly the buy-to-let sector.

Another factor of concern must be the implications for house prices and values, which have been rising at an average of about 20 per cent per year.

I have long argued that house price inflation in Scotland is much too high and that there must be a correction soon – hopefully not a collapse, but a few years of sustained falls in real terms. How that affects consumer confidence will be very important.

One of the main reasons for the recent large increases in prices has been the view that property is a safer investment than the stock market – particularly after the dotcom collapses – and other alternatives.

Thus sharp falls in house values must reduce consumer confidence and, in turn, consumer spending. Nevertheless, there are no signs of that happening.

Another important factor is the implications for exchange rates. We have a relatively large export sector in Scotland, as exemplified by the whisky industry and also tourism, which is vulnerable to changes in the external value of sterling.

The US dollar is plummeting against the pound and most other currencies, which will make our exports to the US more expensive. On the other hand sterling has been falling against the euro, which helps exporters to European markets.

Changes in exchange rates take time to work through to economic output and employment, however, and there will be no discernible impact in 2008.

Thus, I still believe that my forecast of a modest slowdown in growth from 2.5 per cent last year to 2.2 per cent this year is reasonable on current evidence. Even if I am wrong, there will not be a recession but just lower growth.

Tony Mackay is the managing director of economists Mackay Consultants