In this post I argued that
devolution can offer fiscal policy options that are just as credible as the policy mix that would be available under independence. And these options could be available without some of the costs of independence. .... Scotland does not have to accept a Tory-Lib Dem austerity policy. But it doesn't have to leave the UK political union to do so.
However, I wasn't able to offer any numbers. I suggested that
Further academic research is required on the appropriate form and degree of fiscal devolution for effective stabilisation but there is little doubt that stabilisation at the level of nations and regions within the UK is feasible.
Full and detailed research is still required but I am now able to offer some 'ready-reckoner' type estimates that give some idea of the magnitudes involved. They should be viewed as illustrative and not definitive.
The first point to note is that small open economies such as Scotland, whether politically independent or not, tend to have smaller fiscal and other multipliers than larger states. This is because when the propensity to import from a pound/dollar/euro of extra spending is high much of that spending will 'leak out' of the economy. Ray Barrell, Dawn Holland, and Ian Hurst have recently produced this paper for the OECD, which looks at fiscal consolidation in 18 OECD countries. Using the National Institute Global Econometric Model (NiGEM) they provide estimates of first-year multipliers for different types of fiscal intervention. These multipliers are shown to be larger the bigger the country and the lower the degree of import penetration.
The chart below reproduces their data for the relationship between temporary spending reduction multipliers and import penetration:
Using the estimates provided by Barrell et al we can estimate a spending multiplier for Scotland using a measure of import penetration drawn from the 2007 Scottish Input-Output tables - see here. Scotland's share of imports in GDP/GVA is 0.66, which compares with 0.70 for the Netherlands, 0.72 for Ireland, and 0.80 for Belgium. This gives a spending multiplier of -0.17 for Scotland using the average relationship derived from Barrell et al's work. But this value could be too low if Ireland is a close comparator so we also use the value of Ireland's multiplier of -0.33 in the exercise below.
We now assume that the UK government introduces a fiscal spending consolidation equal to 1% of GDP which can be either temporary or permanent. The impact on Scottish GDP is estimated in Table 1 for different constitutional states:
Under the status quo it is assumed that the UK fiscal multipliers apply, from Barrell et al. GDP falls by a temporary 0.74 percent for a 1 percent of GDP reduction in UK public spending. The permanent fall in GDP is less because the NiGEM model allows for UK monetary policy affects as long-term interest rates fall boosting demand and production.
But under independence Scotland will have its own tax and spend regime and we assume that direct fiscal consolidation applies only in the rest of UK.
However, Scotland is not unaffected.
Around two thirds of Scottish exports go to the rest of UK, representing a 34 percent share of Scottish GDP. So, even under independence with no fiscal austerity from the Scottish Government GDP falls - by 0.25 percent. The permanent impact is lower too under Scottish independence, because we assume that an independent Scotland remains in sterling and therefore interest rates in Scotland move in line with the UK.
What about the impact under devolution?
Under Devo-Max, or full-fiscal autonomy, the GDP effect is assumed to be the same as under independence.
But under Devo-Plus, where we assume the Scottish Government has responsibility for tax and spend equal to 50 percent of its revenues and expenditures, the fall in GDP is greater than under independence but less than the status quo for both temporary and permanent fiscal consolidations.
If a Scottish Government seeks to defend against the fiscal austerity practised by the UK Government, what would be a fiscally neutralising response?
Table 2 illustrates.
Table 2 shows what a Scottish Government would be required to do if it wished to neutralise the impact of a 1 percent UK fiscal austerity on its GDP. Under Independence and Devo Max it would need to raise spending by 0.77 percent to 1.43 percent of GDP. The lower figure is based on Ireland fiscal multiplier of 0.33, the larger figure is based on the 0.17 multiplier derived from feeding Scotland's import share into the relationship estimated from Barrell et al's paper.
What is interesting about these estimates is that size of the neutralising spending increase required under Devo Plus: from 1.5 per cent to nearly 3 percent of GDP. The present UK Government's fiscal consolidation programme is seeking effectively to remove 6 per cent from GDP. So, this would be exceptionally difficult to fully neutralise, if not impractical, under Devo Plus. It would also be a tall order under Independence or Devo Max.
But let no one rush off and seek to argue that this analysis supports the view that Independence is the only constitutional state that would allow Scotland to defend against UK fiscal austerity.
In order to raise public spending to defend against UK fiscal austerity, the Scottish Government would need to increase its budget deficit. To do so it would have to borrow - sell bonds. It is likely that an independent Scottish Government would face long-term borrowing rates that are higher than the UK - see my post here and here. It would also, if using sterling, have to operate under fiscal rules on deficit to GDP and debt to GDP set by the Bank of England. Two issues follow.
First, if deficit and debt levels are already high then an independent Scottish Government's room for manoeuvre to offset UK Government austerity, even partially, may be limited, if not precluded all together by financial market constraints.
Secondly, it is a moot point whether an independent Scotland would be faced with a higher long-term borrowing rate than a devolved Scottish Government borrowing with UK Treasury backing.
In sum, a Scottish Government of whatever constitutional ilk would be severely constrained in defending against a large UK fiscal austerity programme. This is because the Scottish economy is highly integrated through trade and labour market links such as migration with the rest of UK. Political independence would not change this much.