Scottish Economy Watch

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."

Scottish GDP improves

The latest Scottish GDP statistics, published today, for the fourth quarter of 2012, are on the face of it quite encouraging, especially when compared to UK.

The bald statistics show that GDP rose by 0.5% in Scotland in the quarter, while falling by -0.3% in the UK. However, growth in 2012 - calendar year - was at 0.3% identical in both Scotland and the UK.

The position of Scotland and the UK in terms of the recovery of GDP from recession is shown in the chart below.

Scottish GDP stands at -2.4% below its pre-recession peak, slightly better than the position of UK GDP, which is -2.9% below its pre-recession peak. So, still a long way to go before the economy gets back to where it was, in GDP terms in early 2008.

There are two key factors that are complicating the assessment of the GDP performance of Scotland and the UK, both absolutely and relatively, during 2012. The first is the differential impact of the London Olympics. The second is the consequences of declining oil and gas production.

To a certain extent the weak performance of the UK economy in quarter four was a reflection of the temporary boost given to GDP by the Olympics in quarter three. If we look at the growth in GDP between quarters two and four in Scotland and the UK, we see that Scottish GDP rose by 0.8% while UK GDP rose by 0.6%. So, when we smooth out the effect of the Olympics the performance of Scotland and the UK is much closer.

But then there is the complicating factor of oil and gas production which - offshore production - is included in the UK GDP data but not in the Scottish data. Removing oil and gas production gives us the following chart.

Now once declining oil and gas production is removed, which incidentally would have lowered measured GDP growth in an independent Scotland, we find that both Scotland and the UK grew by 0.8% between the second and fourth quarter. Scottish and UK growth is identical.

Once that is done, we see that UK GDP is -1.9% below its pre-recession peak compared to -2.4% for Scotland. So, we can conclude that the recovery continues to be weak in the UK and a little weaker still overall in Scotland.

One hope of the UK Government and many commentators is that the UK economy will recover from the Great Recession by re-balancing away from domestic demand to external or foreign demand, from consumption to investment, and from public to private production. A key factor in this is the desired shift in favour of manufacturing, which is a major exporter. The latest data show that very little progress is being made here as the next chart shows.

However, it is some small comfort that Scottish manufacturing is doing better than UK manufacturing. But the downturn in the fourth quarter in Scottish manufacturing as well as in UK manufacturing takes some of the shine off the good overall Scottish GDP performance in the fourth quarter.

Stronger signs of recovery in Scottish labour market

The latest Scottish labour market statistics published this morning serve further to reinforce the view that a more sustained recovery is now underway.

Employment during the quarter to Dec - Feb 2013 rose by 39,000, or 1.6%, and by 20,000 over the year, 0.8%. In the UK, employment was almost flat, falling slightly by just over two thousand. But over the year, the growth in UK jobs was strong than in Scotland, rising by 1.7%.

Despite this improvement, which is significant, jobs in Scotland are still -2.1% below their pre-recession peak, whereas in the UK jobs are 0.4% above their pre-recession peak. The Scottish jobs position is shown in the chart below

Unemployment fell in Scotland during the quarter by -11,000, or -5.2%. In the UK, in contrast, unemployment rose by 70,000, or 2.8%. The measured ILO unemployment rate is now 7.3% in Scotland compared to a much higher rate of 7.9% in the UK. Over the year, unemployment has fallen by -21,000, or -9.8%. In the UK the number unemployed fell by -71,000 over the year, or -2.7%, a much slower rate of decline than in Scotland.

One factor that has tended to flatter the Scottish unemployment figures compared to the UK has been the rise in the number of inactive workers, which has been stronger here. This has tended to depress the measured Scottish unemployment rate compared to the UK. However, in the most recent quarter the number inactive fell by -23,000, or -1.5%, whereas in the UK inactive numbers rose by more than 25,000, or 0.1%.

The fall in inactive numbers has reduced my estimate of the 'real' level of unemployment; see earlier blogs, as the chart shows

'Real' unemployment is now 55,000 higher, at 9.1%, than measured unemployment compared to 78,000, at 10.4% in the previous quarter.

The latest jobs and unemployment data are encouraging and taken with the latest GDP data, see forthcoming blog, do suggest that the Scottish economy is recovering if slowly from the recessionary period.

However, it is worth sounding a note of caution. From the latest data, to December 2012, it appears that full-time employment continues to fall, with jobs growth driven by the growth of the part-time and self-employed. As I noted here we can only be certain of a sustained recovery in the Scottish labour market when the number of full-time employees begins progressively to rise.

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.