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.

Good news on Scottish jobs, but why?

The latest labour market data published today reveal that conditions in the Scottish labour market continue to improve. In the quarter January to March unemployment fell by just under 7,000 to below the 200,000 mark to 199,000, or a rate of 7.3%. The chart below shows that unemployment is now faring better in Scotland than the UK.

What is striking about these latest jobs market data is the surge in employment in Scotland. Jobs rose by 54,000 in the first quarter of this year compared to a fall of 43,000 in the UK as a whole. This brings Scottish jobs performance since before the recession more into line with the UK as the following chart shows.

Scottish jobs are now -1.3% below their pre-recession peak, whereas in the previous quarter they were more than 3% below the pre-recession peak. This is still worse than the UK, where, despite the loss of jobs in the recent quarter the total is 0.6% above the pre-recession peak.

So what is going on here?

First, we cannot discount the possibility that the Scottish data reflect measurement or sampling error, more so than the UK data where samples are relatively bigger. The latest 'surge' may reflect a correction of earlier errors, or a large error in the latest measurement. Only later data will help clarify that.

Secondly, if we assume no measurement error, the explanation could be as follows.

Since the fourth quarter of 2009 when there was a large loss of jobs in Scotland, the Scottish jobs market has been weaker than the jobs market in the UK as a whole. Yet, GDP growth has been very similar in Scotland and the UK. On the face of it, that meant that productivity worsened more in the UK than Scotland. Again we also cannot discount measurement error affecting the GDP estimates both in Scotland and the UK. There may also be different industrial/structural reasons, including the relative number of 'zombie' firms in Scotland and the UK, which would affect the relation of employment to output in Scotland and UK - I assume that the contribution of such firms to GDP is much less than their contribution to employment, other things equal.

But setting all those possible explanations aside, maybe, just maybe, Scottish employers took a more pessimistic view of the course of the recession and recovery than their UK counterparts. Hence, employment was cut back here but nor in the UK. Now we may be seeing a correction as Scottish employers revise their expectations up considering that conditions are not as bad as they expected. Conversely, UK employers may be in the process of revising their expectations downward: the recovery is not as strong as they anticipated, hence cutback on employment.

Only a theory, but it does reconcile the different Scotland-UK jobs market behaviour with the similar output/GDP behaviour.

What do you think?