Scottish Economy Watch

Scottish Independence: assessing the case for and against

What conclusions can prospective referendum voters draw on the economic case for and against independence presented by the 'Yes' and 'No' campaigns in the last few weeks?

(I include here the full version of the brief article that appears, along with the views of 4 other economists: Jim & Margaret Cuthbert, David Bell and Jo Armstrong in today's Sunday Herald)

From the Scottish Government we have had the publication of the report of the Fiscal Commission Working Group, including 2 Nobel Prize winners in economics amongst its authors, which set out a possible macro-economic policy framework and policy options in an independent Scotland. This week the Scottish Government published Scotland's Economy: the case for independence, which purported to explain why independence is an essential step in securing a more prosperous and fairer economy.

To be set against this we have had two publications from the UK Government as part of its Scotland Analysis programme. The first covered Currency and Monetary Policy issues in an independent Scotland. The second, published this week, sought to address the position of Financial Services and Banking in an independent Scotland.

As an economist seeking to evaluate these documents, the first conclusion I would draw is that voters should try and read the documents and not rely on the views and opinions expressed about them by the spokespersons for the 'Yes' and 'No' campaigns. And, yes, don't even rely on the views of commentators like myself.

The question that voters want answered on the economy is fairly simple, I think. They want to know will they be better or worse off if Scotland becomes independent. Some more farsighted might also want to know whether their children and grandchildren will be better or worse off. The two questions do not necessarily have the same answers. And both questions, embodying speculation on many future unknowns, are difficult if not impossible to answer with certainty.

So how are the two sides doing?

First, in my opinion, the quality and depth of analysis in the two UK Government papers far exceeds that in the Scottish Government's case for independence paper. We can set aside the report of the Fiscal Commission Working Group because that report, worthy as it is, does not seek to argue the case for an independent Scotland. Rather, it seeks to address the brief: what macro-economic policy framework should be put in place in an independent Scotland?

The two UK Government papers on the economy published so far are well grounded in theory and evidence. Written by civil servants, they are more balanced and objective than the pronouncements of the UK Government politicians and 'No' campaign officials. Both papers make a good case in identifying the risks to the economic well-being of Scots if they choose the independence route. The currency paper does this best because given the Scottish Government's declared option of retaining sterling, the paper very powerfully argues that this would be a second best to the present arrangements within the union. What that paper does less well is make the case that adoption of an independent Scottish currency after independence would necessarily be worse.

Both UK Government papers have to speculate on possible outcomes and it is inevitable that they focus more on worst-case scenarios and ignore the possible up-side. So the financial services paper makes a strong case that an independent Scotland would be in a weaker position to support the financial system given its relative size than is the case in the present UK. But future crises might not emerge and in the event of crisis there might be scope for a Scottish Government to internationalise the problem. I doubt it, but it is possible.

The Scottish Government's paper in contrast has a more difficult task. It chooses not to talk down Scottish industry but at the same time it wants to suggest that performance would be better under independence. So underperformance has to be laid at the door of the union. And policy in an independent Scotland would be more favourable to competitiveness and growth.

It doesn't succeed in doing any of this.

The paper provides stats on Scotland's growth rate over the past 34 years to 2011. Scotland's growth is a little weaker than both the UK and small EU countries. But not by much. At 2.3% annual growth in Scotland between 1977 and 2007 compared to 2.8% growth in the comparator countries, Scottish GDP would have doubled by 2008, while comparator country GDP would have doubled by 2003. Some might query whether that gap is of sufficient size to warrant breaking the UK union.

But, in fact the gap isn't necessarily that large. If the paper had included the available data from the 1960s it would have shown Scotland growing more strongly than the UK and possibly the small EU countries. The choice of start date is therefore spurious and clearly designed to suit the Scottish Government's case.

Even if we accept that Scotland has a growth deficit compared to say the small EU countries does the Scottish government's paper demonstrate the cause? I think any reasonable observer would answer no!

In the paean of praise to Scottish industry there is no mention of historic weaknesses such as a low business birth rate, low business research and development spend, low innovation, low quality investment and adoption of managerial best practices. These problems have bedevilled Scotland's development and enterprise agencies for years. It is difficult to see how such problems can be laid at the door of the UK union, particularly when other non-metropolitan parts of the UK do better on some or all of these indicators.

But even when the paper does focus on perceived deficiencies of the union we are offered largely ad hoc explanations such as no oil fund, credit boom in the 2000s, inequality high in UK, the austerity policy of present UK Government, recent UK cuts in capital spending and so on. There is no systematic explanation of how their perception of weaker Scottish growth over the last 34 years is the fault of the UK union.

Moreover, there is little if anything proposed on the policy programmes that an independent Scottish government would deploy to raise the well being of the Scottish people. Even if independence was necessary for improved well being, which I don't think it is, we are almost asked to believe that it will be sufficient.

The Scottish Government and the 'Yes' campaign can do much better. The UK Government also needs to be more willing to admit there are many unknowns and that independence might offer benefits as well as the costs.

But don't believe me, read the documents yourself.

 

Banks and Scottish Independence, again!

Following some of the comments and responses to yesterday's post on the banks and Scottish independence, I feel I should write some more on the issue.

David Comerford makes the important point that I have ignored the process of 'subsidiarization' of foreign banks. He cites the recent talk in Edinburgh and Research Briefing paper from Angus Armstrong of the National Institute of Social and Economic Research. What Armstrong notes is that the US Federal Reserve and the Bank of England are moving towards ensuring that

Banks operating in the UK market with headquarters outside of the border would be required to be subsidiaries with their own regulatory capital and reserves held at the Bank of England. If this makes resolution easier this may make support for foreign banks (including from an independent Scotland) operating in the UK easier in future.

Subsidiarization will make the provision of liquidity to banks in the rUK from an independent Scotland easier than I allowed in my first post. This is because while liquidity is, in principle, only provided to solvent banks, they may unknowingly be at risk of insolvency. The requirement of subsidiarization with regulatory capital and reserves held at the Bank of England would minimise the risk to the rUK taxpayer and so liquidity support from the Bank is more likely to be forthcoming.

But that says nothing about the provision of both liquidity and bail-out support in the event of insolvency to banks, Scottish and foreign, operating in Scotland.

Armstrong, in the same paper, notes

For a newly independent country with a high debt to GDP ratio the capacity to support the financial system will be limited. ....... To prevent capital flight savers and investors must believe their money will always be safe in an independent Scotland.

To secure this, Armstrong offers three options: a new Central Bank of Scotland; joining the eurozone monetary union; fiscal agreement between the UK and an independent Scotland. But it is clear from his paper that the first two are not politically feasible and bring economic costs. So that leaves us with a fiscal agreement between the UK and an independent Scotland. And that is precisely what I wrote would be required in my first post.

Comerford further suggests in the context of subsidiarization that RBS and Lloyds could capitalise their English operations under English rules. But why would they want to do this if an independent Scotland was as safe to operate as the rest of the UK?

But Comerford is right to suggest in this context that the scale of the activities in the financial services sector need not change with independence. What I and I believe the Treasury paper was concerned about is the loss of some HQ functions and quality jobs rather than wholesale relocations out of Scotland. That would be unlikely.

Finally, Comerford believes that

John Swinney is correct to say that the importance of financial services to the Scottish economy is smaller than its importance to the rUK economy (but specifically the London economy) and to say that the scale of the activities of the financial services sector need not change with independence.

But John Swinney was using the smaller share of financial services in Scottish GVA not to say that the scale of such activities would not change after independence but to imply that the sector is no more at risk than in rUK; that the capacity of an independent Scottish state to support the financial system would be no less than the rUK. The Treasury paper and Armstrong's paper clearly disputes that.

Yes, financial services are much more important to the London economy in GVA terms as well as scale of assets. But no one is suggesting that London is seeking independence. On the other hand with Boris at the helm ....... !

 

Banks and Scottish Independence

The new Scotland Analysis paper on Financial Services and Banking published by the UK Treasury today makes inter alia the point that in an independent Scotland

"The Scottish banking sector would be exceptionally large compared to the size of an independent Scotland's economy, making it more vulnerable to financial shocks than it is as part of the larger UK."

Scotland's Finance Secretary John Swinney's response, to an issue that I have raised in this blog, for example, here, seems to be two-fold.

First, new regulatory provisions since the financial crisis will prevent such crises from happening, as in this quote:

"The Treasury paper seems to be based on a flawed, outdated view of the world which takes no account of the substantial banking reforms which have been ongoing across Europe since 2008."

Secondly, even if such a crisis occurs again financial services are less important to Scotland than they are to the UK as a whole, as in this quote

"Assertions and claims about Scotland's financial sector are entirely misleading - in terms of share of GDP, in fact, financial services are actually smaller for Scotland at 8.3% than the UK at 9.6%. So, if the argument is about risk, then the risk is with the UK."

Both of these responses are facile and in serious error.

While regulatory reform of banking is welcome no one seriously believes that the risks of a serious banking crisis in the future are much reduced. Some such as Andy Haldane of the Bank of England believe progress in this regard will have only been achieved when the size of banks and UK banks in particular is reduced. Others, including this distinguished academic in the field, believe that banking crises are an ever-present risk in capitalist economies.

Secondly, when Andy Haldane talks about size he is not referring to value added but to the size of the assets, or loans and investments, of the bank. As we see in this chart from the new Treasury paper the current size of banking sector assets would be 12.5 times GDP in an independent Scottish state compared to just under 5 times GDP in the whole of the UK.

Implicit in John Swinney's use of the GVA figure is the belief that because the Scottish banks have much of their business located abroad, there would automatically be an international solution if there was a need for a bailout of the 'Scottish' banks. But this flies in the face of the experience in the banking crisis of 2008-09. It is worth recalling Governor of the Bank of England Mervyn King's comment that

"Banks live globally but die locally."

What John Swinney and the 'Yes' campaign need to do is to first of all accept that there would be issues for an independent Scotland given the asset size of its banking sector. Following a serious crisis some international solution could be possible but it will not be automatic as John Swinney seems to imply.

The 'Yes' campaign and the Scottish government need also to address some of the other issues raised by the Treasury report and noted by Robert Peston in his blog today.

First, it is not simply a question of whether the banking sector could be bailed out in the event of bank failure in an independent Scotland. There is also the question of whether banks would have access to sufficient liquidity from the Central Bank if commercial sources of finance dry up as they did following the collapse of Lehman's in September 2008 and the eurozone banking crisis in 2012. This would depend crucially on the currency arrangement adopted by the government of an independent Scotland. And if access to liquidity from the Bank of England is desired then this could only occur if an independent Scotland was a member of a formal sterling currency zone with all that would imply in terms of restrictions on Scottish government fiscal policy and bank regulation.

Moreover, if the financial markets believe that an independent Scottish government will not have as deep pockets, or have access to deep pockets, as the UK government, then they may be more reluctant to lend to the banks, or would charge higher rates. Borrowing costs for the Scottish banks could therefore be higher.

Taking such circumstances together the risk of the two main Scottish banks relocating their headquarters outside Scotland would clearly be high.

John Swinney's glib responses today in no way address any of these issues.

Sterling and Scottish Independence

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.

I have blogged extensively on the issue - e.g. here and here - and broadly my views coincide with the thrust of the Treasury 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.

But wait!

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."

Scotland's Public Sector Net Debt

Yesterday the Scottish Government produced a paper where estimates are provided of Scotland's historical notional share of UK debt interest payments and public sector net debt.

The paper identifies UK public sector net debt at the end of 2011-12 as £1,100 billion, which amounted to 72% of UK GDP. Applying a per capita share to Scotland, produces an estimate for Scottish public sector net debt of £92 billion. This amounts to 62% of Scottish GDP, since with a geographical share of oil Scotland's GDP per capita is estimated to be greater than the UK.

One can accept this estimate provided one does not then conclude that the burden of debt in an independent Scotland is ten percent points lower than the UK. We cannot conclude this because, as I and others have noted, an independent Scotland will be faced with a higher interest rate on its long-term government borrowing than the UK.

More controversially, the Scottish Government's new paper goes on to estimate an illustrative historic share of UK net public debt. The Scottish Government describe this estimate of Scotland's net public debt as being based on:

estimates of public spending and tax receipts in Scotland over the past thirty years, in other words, on the basis of what Scotland has actually contributed to UK tax revenues

On this basis, the Scottish Government estimates Scotland's share of UK net debt to be £56 billion, equivalent to 38 per cent of GDP.

These estimates lead Deputy First Minister, Nicola Sturgeon to conclude that:

Both of the methodologies show that Scotland's estimated share of national debt takes up a smaller proportion of our economy than is the case for the UK - which means that in all circumstances Scotland will be better off with independence.

I have already noted that these estimates ignore the cost of borrowing, which is likely to be higher in an independent Scotland. But a moment's further thought should lead one to question the Scottish Government's illustrative historic calculation.

First, it seems a reasonable logical argument that as part of the United Kingdom Scotland should broadly be expected to share on a per capita basis in UK public spending, taxation and debt. Asking Scotland to take a per capita share of UK debt if Scotland decided to leave the UK union would seem to be reasonable, since everybody in the UK might be said to be in the same boat together.

However, the Scottish Government suggests that a historic calculation may be more appropriate. But in computing their 'historic' estimate they confine the calculation to the cumulated fiscal balance, including a geographic share of oil revenues, since 1980/81. This is then expressed as a ratio of the cumulative UK deficit over the same period (5.1%) and that ratio is taken to be Scotland's notional share of UK public sector net debt (£56 billion).

But if we are to compute Scotland's share of UK debt on an historic basis, shouldn't we also allow for special Scottish factors that directly affected the level of UK public net debt?

One obvious and significant omission is the bailout of the two Scottish banks in 2008-09.

The National Audit Office estimates that the amount of cash - requiring to be borrowed - for the bank bailout was £124 billion. The share of the two Scottish banks amounted to £67 billion. If we assume that a population share of this number is allowed for in the Scottish Government's 'historic' estimate, this leaves a further £57 billion to be added to the £56 billion debt estimated by the Scottish Government. £113 billion of debt amounts to 77% of Scottish GDP including a geographical share of oil value added.

The new estimate is shown along with the Scottish per capita estimate and the UK net public debt share in the following chart

On this basis and adjusting to gross debt figures as the Scottish Government do in their Chart 4, Scottish gross debt on an historic basis would rise from 44% to around 90%. This would raise Scotland in the debt EU-15 debt ranking from the Scottish Government's rank of 14th from 16 (adding Scotland to the EU-15) to 6th from 16.

This, and remembering the point about borrowing costs, certainly doesn't appear to support Nicola Sturgeon's contention "that in all circumstances Scotland will be better off with independence."

 

Scottish Tax and Spend

Today the Scottish Government published a two-page document providing a summary of trends in total Scottish tax receipts since 1980-81. The summary allocates to Scotland a geographical share of North Sea Oil revenues and draws from experimental statistics of Scotland's fiscal balance which are published on the Government Expenditures and Revenues Scotland (GERS) website here.

The data are not new. The fiscal balance estimates were updated for the GERS exercise to include 201-2 fiscal data and published on 5 March. Nevertheless, the Herald thought the information to be of sufficient importance to run the story as its main feature under the headline "New Report: Scots paying more tax than rest of UK" Given prominence in the story was a quote by Finance Secretary John Swinney from the government Press Release accompanying the report:

These figures confirm what we have known all along. Scotland more than pays her way in the UK. They show that the average tax receipt per person in Scotland has been higher in each of the last 30 years than it has been across the UK as a whole.

As the chart below shows John Swinney's comment is correct.

However, what was not reported in the Herald, wisely in my view, was John Swinney's further comment in the Press Release:

With the full control of our finances we could have invested this money for the people of Scotland, creating jobs and investing in public services.

The 'new report' does not contain any information on spending. An examination of the spending data on the same per capita basis as the tax data and taken from the GERS website reveals the following:

Yes, spending per person in Scotland has also been higher in each of the last 30 years than it has been across the UK as a whole.

So, broadly, these greater tax receipts were invested for the people of Scotland, creating jobs and investing in public services.

The Scottish people have received a significant dividend from North Sea oil revenues, much more than people in the rest of UK.

Now, it is clear that oil revenues were exceptionally high in real terms in the 1980s - as the tax receipts chart indicates. The Scottish people might legitimately note that the greater spending received in that period was much lower than the tax receipt surplus.

A sense of this can be gained from the final chart, which expresses per capita spending in Scotland and UK as a ratio of per capita tax receipts. This is really another way of expressing the fiscal balance data as I did in this post.

The large scale of oil revenues in the 1980s meant that Scotland would have been in surplus - ratio less than one. But from 1990 the spending to tax ratio has tended to be similar in Scotland as in the UK, in fact a little higher in Scotland at 1.11 compared to 1.10 in the UK.

So, if we are to talk about a country 'paying her way', we need to bring into account spending as well as revenues. Public spending per capita has averaged more than ten per cent (10.86%) higher in Scotland than in the UK since 1990/91, while tax receipts (including a geographic share of oil revenues) have averaged less than ten per cent (9.67%) higher in Scotland than in the UK since 1990/91.

With the independent Office of Budget Responsibility predicting (page 102 of its March Economic and Fiscal Outlook) a sustained decline in future oil revenues from £11.2bn in 2011-12 to £4.3bn in 2017-18, Scottish tax receipts are set to fall relative to the UK.

And of course I have not brought into this discussion the issue that an independent Scotland is likely to have to pay higher borrowing costs than the UK as I noted in this and this post. It is not just the size and relative size of a government deficit that matters.

Funding costs must also be considered.

It's not just size that matters.

The spin and hype from the 'yes' and 'no' campaigns after the publication of the Government Expenditure and Revenues Scotland (GERS) was enough to make the eyes water.

In 2011-12 the estimated net fiscal balance (with a geographical share of oil) is -5% of GDP compared to the UK's balance that year of -7.9%.

The 'yes' campaign and supporters of independence argue that GERS demonstrates that Scotland's fiscal position is better than the UK. The 'no' advocates highlight the importance of north-sea oil revenues amounting to £10bn, or 17%, of estimated current revenue. North-sea revenues are volatile and projected by the OBR and others to be in long-term decline. The size of Scotland's net deficit is likely to worsen both absolutely and relative to the UK.

In a sense both sides of the campaign are correct, although for the Scottish Finance Secretary John Swinney to say that the figures showed that Scotland was better off to the tune of £824 per person is stretching it a bit. We didn't have a bigger surplus but a smaller deficit, courtesy of oil revenues, of £7.6bn, or 5%.

The 'no' campaign also need to be reminded that there will be policy options open to an independent Scottish government to help reduce spending, raise taxes and lower the deficit e.g. less defence spending, policies to stimulate migration that will mitigate Scotland's developing demographic problem etc. GERS offers a static picture with the finances likely to evolve after independence.

Yet, a deficit will still have to be funded. And what is important is not just the size of the deficit but the cost of funding it i.e. the cost of borrowing.

As I noted in this detailed post a newly independent Scotland is likely to have higher borrowing costs than the UK for three reasons.

First, a recently independent Scottish government, with no previous experience of and reputation for fiscal management will have a credibility problem. That problem is likely to be worsened by both the high levels of debt that will be inherited by the new Scottish state and the fears of a continuing structural deficit, which will have to be financed.

Secondly, Scotland is much smaller relative to the UK and its finances are likely to be more volatile because of its size. According to OECD evidence small countries tend to pay a risk premium on their borrowing simply because of their size. Moreover, Scotland's dependency on oil revenues is an additional factor increasing the risk of volatile tax revenues and hence the demand for a risk premium by purchasers of Scottish government bonds.

Finally, an independent Scottish government that chooses sterling, for the very good reasons noted above, will effectively be borrowing in a foreign currency. The implication of this is that the financial markets will perceive Scotland to be a greater default risk compared to a state that can meet its obligations by printing its own currency.

So, we cannot simply judge the health of an independent Scotland's public finances by the scale of its likely deficit, the cost of borrowing is as important.

It's not just size that matters.

 

Should Scotland be in EU if rUK out?

In a speech to the British Irish Chamber of Commerce in Dublin last week Nicola Sturgeon, Deputy First Minister is reported to have said:

"It is no longer fanciful to consider as real the possibility the UK is heading out of the EU. Let me state emphatically this is not a journey the Scottish Government wishes Scotland to be a part of, nor one I believe would be supported across the Scottish business community or wider civic society."

I have no sympathy with what Prime Minister Cameron is seeking to do re a referendum in the UK on EU membership. But if, hypothetically, the UK did leave the EU is Nicola Sturgeon correct in arguing that it is in Scotland's interests to stay in the EU?

I do not think the issue is as clear-cut as she pretends.

Take trade for example. The following chart, constructed from the recently published Scotland Global Connections 2011 highlights the importance of trade with rest of UK compared to EU trade.

Scottish exports to rest of UK are four times bigger than exports to the EU (ex UK). Moreover, the importance of rest of UK exports to Scotland is rising while the share of exports to the EU has fallen over the period. And that is after a 15 percent increase in the nominal value of exports to the EU between 2010 and 2011, taking the share from a low of 15 per cent to 16 per cent.

Given these data it would appear to be exceptionally foolhardy of any Scottish government to risk trade, investment and migration links to the rest of UK by staying in the EU if the UK left.

On the other hand, foreign investment and skilled labour immigration to Scotland from the EU and other countries could be damaged if Scotland left the EU. And, the impact of Scotland in-rUK out on Scottish trade might be softened if a free trade arrangement was negotiated by rUK with the EU.

So, it is not at all clear that in such circumstances staying in the EU would be in the best interests of the Scottish people. It would be by no means an easy decision for a Scottish government - if independent - and it is rather remiss of Nicola Sturgeon to present it as such.

Scotland is not Slovakia

It was reported in the Scotsman on Wednesday that the President of the Czech Republic Vaclav Klaus had raised doubts that an independent Scotland could successfully keep using the British pound. This was because when Czechoslovakia split into the Czech and Slovak Republics in 1993 it took only 38 days for the currency union to split.

His views led to a rush of comments from supporters of the UK union arguing that a currency union is only possible with political union. Then a spokesman from the Treasury asserted that protectionism grew between the Czech Republic and the Slovak Republic after the split. The evidence cited by the Treasury spokesman was the fall in Slovak exports to the Czech Republic from 42 per cent of all exports to 13 per cent between 1993 and 2003. Conversely, Czech Republic exports to the Slovak Republic fell from 22 per cent of total exports to 8 per cent. He noted ominously that currently 59 per cent of Scottish exports are to the rest of the UK.

While the basic facts cited are correct, the interpretations put on them by Vaclav Klaus and the UK Treasury spokesman are, shall we say, at odds with the truth.

Scotland in 2012 or 2014 is not the Slovakia of 1992 or 1993.

First, Czechoslovakia was a planned economy, part of the Soviet bloc that practised autarky and state direction of production and resources. At the time of the split, the eastern bloc had dissolved and the two new states were seeking to become market economies increasing their trade and other economic links with the wider world.

Slovakia was much the weaker state, heavily dependent on resource transfers from Czech, with GDP per head 76 per cent of Czech figure, having risen with the help of a state policy promoting convergence, while labour productivity stood at around 89 per cent of the Czech figure as this table shows:

Note also from the table that wages were much closer at 97 per cent of the Czech average monthly wage. Hence, Slovaks were consuming much more than they were producing. This leads on to the second key fact about the Czechs and Slovaks.

Prior to the split, the extent of resource transfer from Czech land to the Slovak lands was about 11 per cent of Slovak GDP and about 4 per cent of Czech GDP - see this very informative research paper by Růžena Vintrová in 2009 from which the above table is taken. The transfer of resources was outstripping the Czech rate of growth and this is one reason why many Czechs wanted rid of Slovakia.

Now, while there is a sizable transfer of resources to Scotland from rest of UK, this is only the case if you do not allocate to Scotland a geographical share of oil revenues. And the average size of Scotland's fiscal deficit, if a population share rather than geographical share of oil revenues is assigned, is 6.5 per cent since 1990. With a geographical share there is still a deficit of 3.6 percent since 1990 but this is much less than 11 per cent - see my earlier post here.

So, the reason why the Slovak Republic chose a 10 per cent one-off devaluation thereby breaking the currency link to the Czech Republic was because as an independent country it was consuming beyond its means, running a large current account trading deficit and a large effective fiscal deficit. Given its low productivity the devaluation was necessary to reduce domestic real wages and get unit labour costs down to more competitive levels.

Further depreciation against the Czech koruna occurred in later years. Slovak wages started to fall relative to wages in the Czech Republic. From almost parity in 1993 at 3 per cent below to 30 per cent below in 2007. This policy was largely successful as the Slovak economy began to diversify away from heavy industry and armament production to new forms of competitive advantage such as motor vehicle production. A diversification based on trade, low wages and imported foreign technologies.

The result of these adjustments was a rapidly growing economy, more diversified and trading with many countries, especially Germany, compared to the pre-split centrally planned days. Hence trade with the Czech Republic fell for growth and market reasons mainly and had little do with a rise in protectionism. This was further facilitated by entry to the EU in 2004.

So, Scotland is not Slovakia. With a geographical share of oil revenues Scotland is close to paying its way, labour productivity levels are almost identical to the UK - see here - although total factor productivity growth could be somewhat lower. Moreover, Scotland is a well developed market economy trading with many nations not a centrally planned, autarkic state.

For these reasons it makes sense for Scotland, if independent, to stick with sterling. A rise in protectionism between an independent Scotland and a rest of the UK state is possible in subtle ways that might circumvent the EU single market. But my judgement is that it would not be great. It would be insufficient to undermine the rest of UK as Scotland's major trading partner and its integrated UK labour market and hence the justification for retaining sterling.

But as the oil revenues begin to run out an independent Scotland will need to raise its performance in manufacturing and tradable services. If productivity growth is insufficient to achieve this then that might be the time for the link with sterling to be broken. While if Scotland remains within the UK, the burden of such adjustment will be borne by the whole of the UK.

Labour Income Shares in the Scottish Economy

The STUC's valuable report A Just Scotland see here, raises many interesting questions which the two campaigns for and against independence need to address. One issue they raise in the report is the labour market and the lack of a debate on the likely structure and regulation of the labour market in different constitutional scenarios.

The STUC clearly fears that the current UK approach favouring flexible labour markets has been accepted by both sides of the constitutional debate when they believe the issue should be debated.

I agree.

The STUC argue that flexible labour markets produce "an economy where work is less well paid, less secure and less permanent." In addition, they note the "completely overlooked" macroeconomic consequence of a falling wage share, which, they go on to suggest:

If the wage share in the economy of an independent Scotland continues to fall then the only way in which the products and services the economy produces can be consumed is through rising debt. This hardly provides for the foundations of a stable, prosperous society. (Page 13)

While welcoming further debate, I think the issue is a little more complicated than this.

First, there is an issue about flexibility. A labour market lacking in regulation seems certain to produce 'sweat shop' conditions, low wages and insecurity. Conversely, a labour market that is heavily regulated seems likely to lead to high hiring costs and low job creation. I'd like to see what the evidence shows on this.

The issue then is can we find an 'optimal' degree of labour market regulation and flexibility that protects workers from vindictive and exploitative employers, while at the same incentivising firms to hire workers and so create jobs? That is the question where I would like to see more theory, evidence and debate.

Secondly, the data on labour shares do not, as far as I can tell, support a view that labour's share of income has been consistently falling in Scotland. The latest Scottish National Accounts Project (SNAP) - experimental - data on compensation of employees is shown in the chart below

Clearly, the data only start in 1998 so I am not sure if the share was falling during the 1990s after the so-called 'Thatcher revolution'. But what the SNAP data show is a rising labour share from 59 per cent to 66 per cent between 1998 and 2001. Then the share fell gently to 62% at the beginning of 2008 when the recession was beginning to bite. During the recession and after the share has oscillated around 63 per cent.

So there is no downward trend during this period of data and other factors seem to be in play as a determinant of labour income share in addition to the UK's fairly flexible labour market regime.