There would be no "massive positive contribution" to the Sterling Zone's balance of payments following Scottish independence.
Now that the dust has settled after the publication this week of the Treasury's paper on currency and monetary policy options in an independent Scotland, it is time to stand back and reflect.
As you might expect there have been the usual exchanges between the 'Better Together' advocates and the 'Yes' campaign. And the frequent resort to ad hominem arguments.
My own view is that the Treasury paper provides a solid piece of analysis of the issues facing an independent Scotland. For those who don't accept my view then I would direct readers to the journalist Stephanie Flanders for a - perhaps too - balanced view and to the Oxford academic, and leading macroeconomist, Simon Wren Lewis's blog on the paper.
The key points it seems to me are as follows:
- An independent Scotland would probably be better adopting sterling if it can get an agreement with the UK government. But that agreement would come with heavy restrictions on debt and fiscal policy that the Scottish government might find too onerous.
- A failure to get agreement would if the Scottish government persists with its desire to use sterling produce a 'dollarization' or 'sterlingisation' solution, which would be even less satisfactory for Scotland.
- Under 'sterlingisation' the Bank of England would set monetary policy and interest rates without consideration of Scottish economic conditions and very importantly the money supply in Scotland would be market driven. That means the money supply would principally be determined by what happens to the balance of payments: a deficit/surplus and the money supply contracts/expands. Hence, these variations in money supply would very likely not be appropriate for domestic economic conditions, or the preferred monetary policy stance of the Scottish government. Scottish fiscal policy would therefore have to do more. But that policy is likely to be very restricted not in this case by the UK government but by market constraints such as higher borrowing costs and the difficulties of borrowing effectively in a foreign currency - sterling.
- In these circumstances an independent Scottish currency might be the best option but while there would be benefits there would be a new set of costs to bear that are well documented in the Treasury paper.
The concerned reader might, therefore, ask whether retaining sterling as part of the UK union and dropping the idea of independence might be the first-best solution. This would be a good question, with which I would find difficult to disagree.
The Scottish government and the 'Yes' campaign argue that talk of severe fiscal constraints imposed by a UK government as the price of a sterling currency union, or a failure to get agreement on a sterling union with the UK government, is highly unlikely because
Scotland's continued use of the pound would make a massive positive contribution to the Sterling Zone's balance of payments. For example, Oil and Gas UK estimate that North Sea oil and gas exports, the vast majority of which originate from Scottish waters, boosted the UK's balance of payments by £40 billion 2011-12.
In my view it is unlikely politically that no agreement would be secured with the UK government, at a price.
But is the Scottish government correct to argue that the benefits to the UK balance of payments of Scotland remaining in sterling are so large that the restrictions imposed by a UK government are unlikely to be onerous and could easily be accepted by the government of an independent Scotland?
I fear not.
The Scottish Government and the 'Yes' campaign are fostering a myth about the size of the loss to the continuing UK, or rUK, balance of payments in the event of Scottish independence and withdrawal from sterling.
My preliminary estimate is that the net cost to the rUK balance of payments would be £3.4 billion in 2011-12 not £40 billion. The table outlines the calculation.
What the Scottish government has chosen to ignore are the offsetting flows that favour sterling and the rUK balance of payments in the event of Scottish independence.
The most important ones are:
- the remittances abroad of north sea oil profits which because of the large foreign ownership of oil and gas production in the UKCS I estimate at £19 billion in 2011;
- Scotland had a deficit on its trade in goods and services in 2011 with rUK of £13 billion; this would provide a big boost to rUK balance of payments in the event of independence because currently trade within the UK falls outside the measure;
- Around 20 percent of Scottish GVA is produced by companies headquartered/registered in rUK so profits of these activities are remitted to the rest of UK and would enter the rUK balance of payment positively in the event of Scottish independence. I estimate the value of these to be £5.8 billion in 2011.
Taken together, the net deterioration in the rUK balance of payments following Scottish independence with a separate currency is £3.4 billion. This means that in 2011 the deficit on the rUK balance of payments would have been £23.6 billion rather than £20.2 billion. That represents a small deterioration in the deficit as a proportion of GDP of 0.2 percentage points from 1.3 percent to 1.5 percent.
The upshot of all this is that far from providing a major boost to the rUK balance of payments if an independent Scotland retained sterling, the effect is largely neutral.
There is little in this analysis to deny the contention of the Treasury paper that a formal sterling union following Scottish independence would "require rigorous oversight of Scotland's (fiscal) plans by continuing UK."