Scottish Economy Watch

Martin Wolf in the Financial Times today offers an important contribution to the debate on the economic outcome for an independent Scotland. He focuses on three aspects: the fiscal future, monetary future, the future of Scotland's financial industry.

For Wolf, Scotland's fiscal future as an independent state depends on its share and the behaviour of North Sea oil revenues and its inherited share of UK government debt. On oil, the chart below plots the revenues since 1980-81. Two facts stand out: the revenues are variable and, despite the rise in oil prices over the last 10 years, they are in decline.

Government Revenues from UK Oil and Gas Production (2009/10 prices)

Source: Government Expenditure and Revenue Scotland 2009-2010

On debt and debt interest in 2009-10 UK net debt to GDP was 53% by 2013-14 Wolf notes that it will peak at 71%. Indeed, as the chart below shows it is now expected by the UK Treasury to peak at the higher share of 78% of GDP in 2014-15.

Martin Wolf comments

A newly independent small country with sizeable fiscal deficits, high public debt and reliance on a declining resource for 12 per cent of its fiscal revenue, could not enjoy a triple A rating. Its costs of borrowing might be far higher than those of the UK. To avoid the risk, it would need to lower its debts quite rapidly. This would require even greater austerity than in the UK as a whole. Given its close ties to the rest of the UK, Scotland could not get away with taxing corporations or skilled people more heavily than its neighbour. So the bulk of this extra austerity would surely fall on public spending.

I think Wolf's judgement is broadly correct, even though we must remain sceptical about the role of the ratings agencies. The experience of small independent countries such as Denmark, and Sweden shows that they can enjoy low borrowing costs, often lower than the UK. But such lower costs have to be won by convincing the markets that the government will be fiscally prudent, stable, with good growth prospects. Building that reputation takes time.

We can go further than Wolf and note that the evident volatility of the oil revenues given their importance to the overall Scottish budget, will pose problems in the planning of future expenditures. We need to know from the advocates of Scottish independence how they propose to deal with this. A prudent Scottish Chancellor might decide that it may be better to bank some or all of the oil revenues in an 'Oil Fund' for future investment and contingencies. But if he/she does that then public spending would have to be reduced further.

Wolf does not discuss the SNP's view that tax policy, via lower corporation tax, would boost the growth of the Scottish economy and hence the flow of tax revenues. It would be interesting to see the analysis of the expected return from a lower corporation tax and the scale of the anticipated revenues in an independent Scotland. It does appear that the nationalists are putting a lot of eggs into the corporation tax basket with little evidence that the return would be sufficient to prevent the factors likely to depress public spending, noted above, and growth, noted below. Moreover, the right to vary corporation tax may be an option within the UK union. Northern Ireland seems to think so.

On an independent Scotland's monetary future a key issue as Martin Wolf notes is the choice of currency. It would be extremely dangerous if Scotland immediately adopted its own currency. The exchange rates of currencies of small independent states are extremely volatile unless they link in one way or another to a larger monetary union. The small scale of the foreign currency reserves held means that such countries are extremely vulnerable to speculative attack, extreme swings in their exchange rate and the exchange risk and heightened uncertainty for business.

George Kerevan has recently argued (14 January in Scotsman - no link) that a Scottish central bank would easily be able to retain parity with sterling by buying and selling Scots pounds. But given the small size of Scotland, the inflationary risks that would result from his proposal would be considerable. He cites North Sea Oil discoveries and investment as likely to push up the Scots pound exchange rate. And he considers the purchase of foreign currency required to stabilise the exchange rate to be a great advantage because it would give the government 'healthy reserves'. But he fails to appreciate the inflation risk of such a policy as we have seen recently with the Swiss franc. Moreover such a policy might still fail and so the government in order to sustain the policy would have to adopt capital controls, which could have a negative effect on Scotland's integration into the world's financial markets and the global economy. Failure of the policy would lead to a rising Scots pound and, given the greater importance of oil to Scotland than the UK, the emergence of a 'Dutch disease' problem. Scottish trade in other goods, especially manufacturing, would become increasingly uncompetitive, the industrial base would erode, the dependency on oil would rise and the economic future would be bleak once the oil had gone.

The Chief Secretary to the Treasury Danny Alexander's speech in December to the SCDI, clearly articulating the Treasury view, nevertheless gets the economics on this issue quite right.

Firstly, a single currency over an appropriate area lowers transaction costs in trade. It improves price comparability but more importantly, eliminates the exchange rate risk and the need to hedge against it. Secondly, it helps to impose discipline over inflation by limiting the ability to use exchange rate devaluation to compensate for high domestic inflation. And thirdly, it provides the exchange rate stability that many smaller, open countries yearn for. .... In many ways monetary policy set by the Bank of England is already suited to Scotland given that the United Kingdom and the pound exhibit many of the characteristics of a so-called 'optimum currency area'. For one, Scotland and the rest of the UK are very similar in their industrial structure, business cycle and price volatility.

In addition to the similar industrial structure, business cycle and price volatility Scottish productivity is now much more in line with the UK, but not the core Euro members, as this chart shows. Although, clearly, it is rates of growth of productivity that are key.

Source: Scottish Government, High Level Summary of Statistics Trends - Chart data, https://www.scotland.gov.uk/Topics/Statistics/Browse/Economy/TrendData

It therefore follows that it would be foolish for Scotland to give up the £ sterling for the Euro or a Scots pound. Almost all other variants around sterling such as 'dollarization' or 'sterlingisation' or pegging are significantly second best alternatives to the status quo.

Martin Wolf concludes by noting that given the importance of Scotland's financial centre an independent Scottish government would not have the fiscal resources to back these institutions if they got into difficulty. Hence there is a risk that activities that do much of their business in the residual UK will move south to the UK where security for their depositors and investors will be greater.

Martin Wolf's article provides a dispassionate analysis of the economic issues confronting an independent Scotland. Can the advocates of independence address the issues he raises in a similar dispassionate manner?