Why assessments of Scotland's economy under independence are often misleading

A majority of economists believe that Scotland would be worse off if she were independent, according to a new VoxEU survey. A smaller majority believe that the rest of the UK (rUK) would be acting in its own self-interest if it tried to rule out a currency union. Andrew Hughes Hallett1 explains why both beliefs are misleading. 

To determine if Scotland would be better off or not, one has to reconstruct the national accounts to show how they would appear if Scotland were financially independent. This is because a number of revenue and spending transfers between Scotland and rUK would either cease to exist or be returned to the parent economy. Reallocating those spending and tax flows would change Scotland’s fiscal balances significantly in Scotland’s favour.

This point is now acknowledged in relation to oil and gas revenues, and perhaps debt interest payments; but not with respect to the other transfers and subsidy reversals. In other words, most economists continue to use the national accounts as they are. Insofar as their projections show Scotland worse off, they are showing how the Scottish economy would look if the union continued. That is to make a case for independence, not against it.

An analytic framework
Faced with the need to create an economic policy framework from scratch, we have to start by creating policy system that ensures the economy’s financing needs, as represented in the macroeconomic accounting identity,

S - I = (G - T) + (X - M)

[S=savings, I=investment, G=public spending, T=government revenues, and X-M the current account balance] are always met. That is, the economy must have the capacity to manage three imbalances: the private financing (savings-investment) gap, the fiscal (public spending-revenues) gap, and the foreign financing (trade) gap. This in turn implies we need policies for financial regulation, for sustainable fiscal rules, and for a currency/monetary policy choice.

Scotland as an independent economy, or an economy with a large degree of fiscal autonomy, or as a devolved economy within the meaning of the 2012 Scotland Act, will be no exception.

The first point to realise is that the UK and Scottish governments are engaged in a series of parallel and overlapping policy games. A parallel game is where the same opponents play against each other in more than one arena: in this case, in the political and economic arenas. An overlapping game is where each player is engaged in a game against different opponents, where the strategies pursued in one game limit the strategies available in another. In this case, we have an economic game where the UK and Scottish governments play against each other, but also against firms in the private sector. It obviously impinges directly on the parallel economic and political games.

The solution of these games shows how the threat points — that is the best outcomes that each player can expect to achieve for themselves without cooperating, accommodating or otherwise making concessions to the other player — would alter from their status quo ante position. To illustrate, the currency choice poses a significant dilemma for both governments, although the outcomes for Scotland in the absence of cooperation, concessions or a formal currency union would be a considerable improvement of the current status quo position; while rUK would inevitably suffer worse economic outcomes.

To see this, one has to recognise that the UK government can do nothing to prevent Scotland taking the pound if she wishes,2 any more than the US government can stop Ecuador using the US dollar. All rUK can do is deny Scotland any influence over policy at the Bank of England. But that is just to reproduce the current position for monetary policy in Scotland. Nothing would change for Scotland if London were to refuse to share sterling and monetary policy, since it doesn’t share them now. Given independence, or fiscal autonomy, the only difference would be that Scotland gets to add tax powers to the existing monetary set up. She would therefore be unambiguously better off: more policy instruments to serve the same targets — instruments that can now be designed to fit Scotland’s specific needs, rather than the UK average.

But rUK would be worse off; not better off since monetary policy would be set exactly as it is now, but worse off to the extent Scotland uses her new tax powers to her own advantage; and because rUK would lose tax revenues/subsidies making her net debt and deficit positions worse.

Financial regulation and liquidity access
The difficulty with adopting sterling unilaterally would be the loss of access to liquidity, and the absence of financial regulation for Scottish financial firms. However Scotland could ‘opt-in’ into the EU banking union, giving her financial sector easy access to liquidity via both the Euro and Sterling markets, and to a wider pool of resolution funds for everything else. The threat point of the economic game shifts again, with consequences for the political game because to block monetary cooperation would start to make a political or fiscal union look financially risky and less attractive for firms in rUK.

Facing a tight general election in 2015, it is hard to believe the UK government would choose to deny a currency union when the consequences would make their own supporters worse off, but Scotland better off. Confusion on this point may explain why conflicting messages are coming from the Prime Minister’s office and from George Osborne as to whether a currency union would be negotiable or ruled out. After the referendum, there will be no incentive for either side not to agree a currency union as long as effective fiscal controls are put in place on both sides. Since the Scottish fiscal position will be stronger (a smaller public debt ratio, and a budget surplus when national accounts are restructured to reflect the changed flows of taxes raised and public spending under independence) this would not be hard to arrange.

It would be harder to persuade the UK government whose fiscal position will be weaker and therefore more of a threat to Scotland than Scotland is to rUK. Sterling without monetary union may therefore be a risky option for Scotland unless it is combined with an opt-in to the EU's regulatory and banking union with formal ECB backing, as in Denmark (also not a Euro member). Faced with uncertainty and mixed messages from the UK government, and deeper liquidity markets, wider rescue funds and a more developed regulatory/banking union system, some financial firms could feel safer in Scotland.

This will not affect Scotland’s banks much since the UK's own legislation (or EU legislation plus Basel III) will force them to reincorporate locally by activity level. The non-bank financial sector (insurance, pensions, asset management) however is three times larger by employment than in rUK. At present the UK is using its old default legislation in this sector; but the EU banking union is creating a new system for non-bank financial services. It would pay Scottish firms to get in on the ground floor to ensure the system is designed in a way that suits them. This they cannot do as long as the UK stands outside the EU regulatory system.

Fiscal imbalances
Under independence or fiscal autonomy, the loss of fiscal transfers from London will be more than compensated by the repatriation of tax powers; that is a restoration of a diversified set of revenues and fully functioning automatic stabilisers, supplemented by an oil fund to stabilise oil and gas revenues. The currency union issue is important here because research on optimal currency areas shows that the bulk of risk sharing in mature currency unions is born by cross-border asset holdings or financing loans. Risk sharing is therefore best preserved if a currency union is maintained.

The office of budget responsibility estimated Scotland’s fiscal deficit to be 5.2 per cent of GDP in 2013/14 — that is for current spending relative to combined offshore and onshore GDP. Many people quote larger figures because they include capital spending, to be paid for by future revenues, and then exclude offshore GDP — the obvious source of those revenues.

Under independence, this deficit figure would have North Sea revenues, positive if falling, added to it (£3.5bn); and then the repatriated taxes from cross-border commuters (£1bn); the return of subsidies currently made to rUK pensions (£1bn); the return or part-return of debt interest payments currently made to the UK treasury (£3bn, using historical debt); plus the gains from defence restructuring (£0.5bn)3; the return of Scotland’s share of quantitative easing assets at the Bank of England (£1bn), and subsidies to housing benefit (£0.5bn). These revenue and spending reallocations imply a fiscal surplus of £1.5bn, or 1 per cent of GDP, before any policy changes or new taxes.

More speculative savings: a) Tax collection in Norway and Finland costs 50 per cent less per unit of revenue; adopting their procedures could save perhaps £400m. b) According to HMRC, levies for banking regulation, resolution and deposit insurance would fall by £300m — confirming that bank assets at risk are smaller than usually advertised. c) One-off costs for creating new government departments: £200m-600m.

Debt: taking a share of UK public debt is resolved by the UK government’s announcement that it would assume responsibility since it holds the legal title. So Scotland could start with no debt and no repayments. The possibility remains that Scotland might agree to assume a share voluntarily to create a cooperative start to the fiscal independence framework, but it is not required. Not to assume any debt would raise the UK’s debt ratio to 106 per cent, being the same quantity of debt divided by a smaller GDP level — about the same as Italy’s debt at the start of the crisis.

The compromise of Scotland’s historical debt figure, obtained by backing out accumulated budget surpluses since 1974 from Scotland's population share of UK debt, would leave Scotland with a debt ratio of 45 per cent or half its population share of overall UK debt.

Credit markets and bank regulation
If the existing models for predicting risk premia for Scotland are correct, then the absence of material deficit or debt levels would lead to lower interest rates in Scotland than rUK after an initial adjustment period. Combined with a clear separation of private from public risk (the banking union being used to resolve the former, a fiscal council the latter), this would lead to lower market rates in Scotland than rUK. Whether this is realistic is yet to be seen; it depends on the supply and demand for financing flows in other sectors and their spillovers onto fiscal imbalances, and on policy changes on either side of the border. But the combined effects of the new regulatory system — that is, the UK Banking Reform Act, conduct regulation, the EU’s banking union and Basel III, will help by reducing the financial assets under Scotland’s supervision to about the level of GDP, while raising those in rUK.

Fiscal rules
The obvious implication of this analysis is that the UK government’s reluctance to entertain the idea of a currency union has more to do with the fear that Scottish fiscal policy might become expansionary and unsustainable than the loss of political control. This is certainly a concern given that the identity at the head of this note applies to any common financial zone; unrestrained expansions of fiscal deficits can easily spillover into higher interest rates, and liquidity stops/capital reversals in the private or foreign capital markets — and ultimately to default in any of those markets. This may require, so the story goes, bail-out funds from the taxpayer to stabilise those markets, re-establish liquidity flows and credit, but creating an attendant incentive for fiscal policymakers to free-ride.

While true, it is important to note that: a) this argument cuts both ways, the UK with weaker fiscal balances could just as easily disrupt the markets as Scotland but to larger effect; and b) while a unilateral adoption of sterling would remove any moral (as opposed to self-interested) obligation to bail out Scotland’s fiscal behaviour, it does not rule out or reduce the chances of disruptions or liquidity shortages. Hence a better way to go is to impose a set of fiscal rules, demonstrably enforceable, and overseen by an independent fiscal commission acting as monitor and fiscal regulator of last resort (‘chapter 11’ administrator) to separate public from private sector financing risks.

Options for fiscal rules:

• balanced budget rules, nominal or structural: the fiscal compact
• debt rules; debt targeting (which implies a primary surplus budget rule)*
• expenditure rules
• revenue rules
• golden rule of deficit financing*
• independent monitoring (to avoid moral hazard); the rules need to be forward looking
• effective enforcement; credible sanctions (they need to be ex-ante, not ex-post)

The UK has used similar types of rules in the past, but no more. The starred rules are the ones Scotland might use. Balanced budget rules/the fiscal compact are not recommended as they are neither necessary nor sufficient for maintaining sustainable debt ratios, and because it is not possible to calculate structural deficits reliably in real time as needed for the policy making process. Expenditure or revenue rules (austerity measures), popular in some quarters, have been criticised for being counterproductive because by operating on one side of the fiscal imbalance they damage the other side; and because they miss the source of the problem if other financing imbalances are the driving force.

Regulation and the Separation Principle
As things stand, private sector monitoring and resolution of banks will be undertaken by the UK’s banking union and financial stability system. But this may transfer to the EU’s Banking Union and the ECB’s supervision system, if Scotland chooses to opt-in.

Public sector monitoring will be conducted by the Scottish Fiscal Commission; with any resolution activities through the UK’s resolution mechanism, the IMF, domestic reserves; or through the EU’s banking union as appropriate.

These two arms of regulation and resolution involve two independent actors; and hence imply the separation of private from public risk:

a) Private resolution will be discretionary under the relevant banking union; currently the national regulators with the local incorporation of subsidiaries as required by the EU systemic risk board, Vickers, UK conduct regulation, parts of Basel III, and UK Banking Reform Act. That implies a jointly owned and operated EU or UK rescue vehicle for the private sector.

b) Public bail-outs are not allowed. A graduated debt protocol and ‘chapter 11’ process under Scottish Fiscal Commission or IMF administration instead.

Conclusion
As the Standard and Poor’s ratings assessment recognises, independence presents ‘significant but not unsurpassable’ changes and risks. The main problem seems to be access to external finance for banks and financial firms, not fiscal deficits or the currency union.

Notes:

1. University of St Andrews

2. To take one example of the currency options open to Scotland. To use this example of a unilateral adoption of sterling is necessary to establish the status quo threat point; it does not necessarily imply that this would be the best option short of full monetary union.

3. Scotland raises £3bn, but £1.8bn is spent. Spending £2.5bn would save £½bn and increase defence capacity.

From issue no. 166, July 2014, pp.20-22

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