Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by Professor S C Dow


  The report on regional productivity which supports the Pre-Budget Report emphasises the need for government policy to promote clusters of economic activity in the weaker regions, in order to reduce regional disparities. There are further senses in which regions can be caught in virtuous or vicious circles, which prevent convergence, given the interdependence at the regional level of availability of finance, financial behaviour and expenditure behaviour. Accordingly, while the report notes the importance of UK-level macroeconomic stability for the regions, more attention could have been focused on the issue of macroeconomic stability at the regional level, and the long-term effects on behaviour of experience of economic (and in particular financial) vulnerability at the regional level when combined with instability. Further, while it is argued in the report that regional sectoral specialisation is not the main issue as far as productivity differences are concerned, it can be significant for the degree of volatility of demand for regional production.


  1.  The Pre-Budget Statement lists full employment in every region in the UK as one of its goals (para 1.4), and includes two measures with a specific (sub)regional dimension: the removal of stamp duty on residential and commercial property transfers of up to £150,000 within tightly-defined areas (para 3.61) and improvements to the Community Investment Tax Credit, which is targeted at disadvantaged communities (para 3.54-59).

  2.  Also flagged up is the report: Productivity in the UK, 3—The Regional Dimension. Since this is intended to provide the basis for future regional policy, the following are some comments addressed specifically to that report. The aim is to highlight some important points made, some issues which arise, and to articulate some views which may be of relevance to future policy-making, but which are not given prominence in the report.

  3.  It is pointed out (para 1.4) that the extent of regional disparities in the UK is substantial. It is further pointed out that, not only does macroeconomic instability tend to increase regional disparities (para 3.4), but also regional disparities may exacerbate overall macroeconomic instability for the UK (para 3.5). Thus the goal of reducing regional disparities is seen to be in the interests, not only of the weaker regions, but also of the UK as a whole.


  4.  Reference is made to a body of theory in economics which concludes that market forces should normally lead to convergence of regional growth rates. This implies that persisting disparities must be explained by "serious market failures" (paras 1.8, 3.2), so that policy should be directed to freeing up markets.

  5.  But, while data showing international comparisons of regional disparities need to be treated with care, the evidence in Box 1. 1 does show that regional disparities are, greater in the UK than in all other European economies -variation in sub-regional GDP is shown to be more than double that within Greece and Ireland, for example. But it is conventionally understood that market forces are given fuller rein in the UK than in the rest of Europe. So there must be other explanations for the extent of regional disparities in the UK.

  6.  In fact the report highlights a sense in which markets themselves fail to promote convergence (and thus where strengthened market forces would worsen disparities): the benefits of agglomeration (para 3.31ff). The market failure here is that, while clusters of firms and workers benefit from proximity to each other, these benefits are not priced, and thus not traded, and so there is little market incentive for coordination in order to establish new clusters. Benefits of agglomeration are frequently used to explain such phenomena as the economic success of Silicon Valley, the Cambridge area, the City of London, the Golden Triangle in continental Europe, and so on. In these areas, there has been a cumulative process of benefiting from agglomeration against which it has been hard for other regions to compete.

  7.  This reasoning provides justification for using government policy to institute regional programmes to counteract the productivity advantage of well-established clusters.


  8.  While most of the emphasis of the report's analysis is on the supply side of regional economies, it is pointed out, in considering case studies of regional policy, that it is demand-driven public investment programmes have tended to be successful (Box 3.2). This suggests that attention needs to be paid also to the demand for regional production, although this is not pursued in the report.

  9.  There are clearly regional differences in specialisation which mean differences in vulnerability to swings in external demand. For example, the Pre-Budget Report notes the regional redistribution effect of tourism expenditure due to the foot and mouth episode (Box A3). The effect is regional changes in unemployment caused by deficient demand for regional production and regional changes in GDP.

  10.  The contribution of unemployment to regional differences in GDP is shown in Chart 1.3. Productivity differences are shown to account for 60 per cent of the regional differences in GDP (para 1.12), more than unemployment, labour force participation and demographic factors put together, and the report proceeds to concentrate on productivity. But there are significant regional variations. In Scotland, unemployment has a similar impact to lower-than-average productivity; in the lowest-per-capita-GDP regions, the North East, Northern Ireland and Wales, lower productivity accounts for around one-half of the differential; productivity differentials are only overwhelming in regions closer to the national average, and in London.

  11.  It is shown further that regional productivity differences apply across sectors (Box 2.1), implying, that sectoral differences are of limited significance. But they are still likely to he important as far as unemployment and labour force participation are concerned, given different patterns of demand, and thus require further attention.


  12.  It is pointed out (paras 3.4, 4.4-4.8) that regional disparities in general, and market failure in particular, can be caused by macroeconomic instability. Instability discourages the making of expenditure plans, and it does so the greater the degree of vulnerability, Thus unstable export demand, unstable presence of foreign direct investment, and unstable availability of credit will have the greatest impact where wealth levels are lowest, that is in the weakest regions. Thus a low wealth base, combined with volatile demand and finance, can be an important contributor to a vicious circle of relative decline. Thus what may appear at the UK level to be a stable macro environment (as with the tourist industry) can mask instability for some regions.

  13.  The significance of lack of information about non-metropolitan regional economies and uncertainty as to risk and expected return from investing there is pointed out (para 3.52) but needs to be highlighted and further investigated. Much of the public discussion about availability of finance implies that "full information" on risk is feasible, so that imperfect information is a curable source of market failure. But corporate investment is a matter of uncertainty, no matter how well-informed. The significance of distance from the location of decision-making for evaluation of risk is well-documented. Further, where there has been experience of vulnerability to swings in economic conditions in the past, and a low wealth base to provide a cushion, then it is rational for potential lenders to assess expected risk as high. This in turn exacerbates vulnerability.

  14.  Households and firms in vulnerable regions accordingly tend to adopt relatively defensive expenditure patterns to reduce exposure to risk. This limits expansion of domestic demand in the region, and also the investment which would provide the basis for growth. Further, as pointed out in the report, an important aspect of a vicious circle for a regional economy is a relative deterioration in infrastructure which further impedes productivity (para 3.39).

  15.  Thus the interdependence identified in the clusters approach extends to availability of finance, to willingness to incur debt and to expenditure patterns. Where regions specialise in export-oriented industry, swings in demand further increase vulnerability.

  16.  While exposing firms in weaker regions to more competition may indeed encourage technology transfer which would reduce productivity differentials, other things being equal, it may be that the local monopoly power of firms serving the local market provides them and their employees with a cushion against instability. This illustrates the importance of sorting out two meanings of the term "market failure" as used in the report to explain regional disparities: factors which reduce a competitiveness which would have encouraged convergence on the one hand, and factors which mean that markets, even operating competitively, fail to promote convergence. Each meaning requires a different policy approach.

December 2001

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