Some Economic Truths About Scottish Independence - Known Unknowns

In less than four weeks, on the 18^th of September 2014, the Scottish electorate will take to the polling stations to decide the future of the 300 year old union between Scotland and the rest of the United Kingdom. As a Scotsman (albeit half Belgian) living in England, this may be one of the most important questions I will never be asked. So I thought I would take this opportunity to answer it anyway by summarising what I think are the key economic issues underlying the question of Scottish Independence.

Clearly, it is extremely difficult, if not impossible, to predict what the economic consequences of either a ‘Yes’ or a ‘No’ vote might be. These are known unknowns. Nevertheless, it is surely better to be aware of the unknown than to be completely ignorant. In my mind there are a number of social, democratic and even economic reasons to support a more autonomous Scottish state. Taking this a step further, independence is an opportunity for Scotland to exercise her right to self-determination. The economic costs of a ‘Yes’ vote however, would be unnecessarily high.

Scotland, a resource rich economy

There is no doubt that Scotland is an extremely wealthy and prosperous nation. According to the IFS (2012) Scotland’s onshore output per head (that is GDP per capita excluding North Sea oil and gas) stood at £22,816 in 2010-11, slightly below the UK figure of £23,242, but behind only London and the South East. Including North Sea oil and gas in the calculation however would, of course, increase Scotland’s output per head. The problem is that the exact allocation of North Sea oil and gas between Scotland and the rest of the UK will depend ultimately on the negotiations between Edinburgh and Westminster under the event of a ‘Yes’ vote. This is likely to be complex process, covering a range of key issues (Trident, currency arrangements, sharing of national debt, etc.), in which the bargaining power of both sides is all but clear. Allocating North Sea output on a geographical basis (rather than a population basis, which significantly reduces the amount of North Sea output attributed to Scotland) increases Scotland’s output per head to £27,732 in 2010-11, making it the 6^th richest country in the world. A key point here however is that, given the significant foreign ownership of North Sea resources, it is not at all clear how much of the extra income from North Sea oil and gas actually contributes to wealth in Scotland. Estimates by the CPPR (2013) suggest that Scottish GNI (output generated by residents of Scotland) is substantially lower.

Despite similar levels of output per capita between Scotland and the UK, the structures of the economies are very different. The main structural difference would be a significant dependence of the Scottish economy on natural resources. According to estimates from the Scottish Government, North Sea oil and gas accounted for 18% of Scottish output in 2012. This is important given the inherent volatility of North Sea oil and gas production, as well as global oil and gas prices. The following chart shows just how much volatility North Sea oil and gas has added to the Scottish economy over the last 15 years.

Chart 1: Quarterly Scottish nominal GDP growth

Source: HMG (2013) “Scotland Analysis: Macroeconomic and Fiscal Performance”

There is substantial evidence to suggest a negative relationship between volatility and economic growth. Particularly relevant for Scotland is the recent empirical evidence of a positive correlation between natural resource dependence and macroeconomic volatility and a negative correlation between macroeconomic volatility and growth (Poelhekke and van der Ploeg, 2009; van der Ploeg, 2011). This relationship appears to be primarily driven by boom-bust cycles induced by volatile commodity prices, debt overhand and credit constraints.

Some stark fiscal realities

Tax receipts per capita were estimated by the IFS (2012) to be £10,174 in Scotland in 2010-11 compared to £8,847 in the UK. This means that total revenues as a proportion of GDP are fairly similar in Scotland and the UK at around 37%. Whilst the make-up of onshore tax receipts is fairly similar in Scotland compared to the UK, the main difference, once again, comes from considering the oil and gas sector. An independent Scotland would be heavily reliant on North Sea tax revenues, which accounted for 15% of government revenues in 2010-11, compared to 1.6% for the UK. The inherent volatility in the oil and gas sector would be translated directly into Scottish tax receipts – over the last 30 years, UK offshore tax receipts have varied year-on-year by 30% on average.

On the expenditure side, government spending is substantially higher in Scotland at £11,801 per person in 2010-11 compared to £10,630 the UK. Scotland spends substantially more on social services, than the UK as well as on personal social services and tertiary education. Putting these together, the current budget deficit as a proportion of GDP was slightly lower in Scotland (6.4%) than the UK (6.6%) in 2010-11; or £1,627 per capita compare to 1,783. So the fiscal positions of Scotland and the UK are, in fact, very similar.

Another important aspect of any country’s fiscal position is the cumulative deficit – or debt. According to the IMF’s WEO (2014) UK net government debt stood at 81.4% of GDP and in 2012. Whilst this is relatively high by both historical and international standards (net debt was 58.1% in Germany, 80.1% in the US and 84.0% in France) the UK is still able to borrow at relatively low interest rates; the current 10-year UK government bond yield is 2.36%, compared to 2.38% for the USA and 1.38% for France. The reasons for such low and stable interest rates are a combination of market confidence in the UK’s track record and growing concern over other major economies’ ability to repay (the recent Argentinian experience is a case in point). In the short term, the biggest risk to the fiscal position of an independent Scotland would be the interest rate charged by financial markets. A lack of credit history, combined with the fact that smaller economies tend to face higher interest rates (Hassan, 2013), means an independent Scotland would likely face higher interest rates that the UK currently does. The exact size of this ‘risk premium’ is hard to gauge but could be substantial.

Over the medium to long term, the fiscal position of an independent Scotland would face two big challenges. The first is the continued decline of the North Sea oil and gas sector. The OBR (2012) expects oil and gas revenues to decline by over 80% by 2022-23. The following charts show the proved oil and gas reserves for the UK since 1980. According to the Oil & Gas Journal (OGJ) the UK’s proven oil and gas reserves stood at 3 billion barrels and 8.7 trillion cubic feet respectively, as of Jan 1^st 2014, and are on a downward trajectory due to aging reservoirs and rising costs. This is in sharp contrast with Norway (also included in the charts) whose oil and gas reserves are the largest in Europe, and still in relatively good health.

Chart 2: Oil and Gas Reserves

Source: Energy Information Administration (EIA) 2014 data

The second major risk to Scotland’s medium term fiscal position would come from rising government spending, the biggest component of which is likely to be the pension bill. The OBR (2012) forecasts the ageing UK population alone will add 5% of GDP to the sate pension bill and health bill. The fiscal pressure is likely to be even greater for Scotland given that the number of people of state-pension age is expected to increase to 401 per 1,000 by 2060 in Scotland, compared to 273 in the rest of the UK.

Of course and independent Scotland would have free reign to set domestic tax policy as well as make decisions on areas of spending currently under Westminster’s control, such as defence and social security which currently make up about one third of public spending. Indeed, as documented in the Mirlees Review (2011), there are a whole host of potential tax reforms that could see an independent Scotland significantly improve the efficiency of the tax system. However, these are issues that face the UK as a whole, not just Scotland. A ‘Yes’ vote would simply force Scotland to make even starker fiscal choices over a much more immediate timeframe.

Currency? What currency?

The debate over the currency regime of an independent Scotland has intensified of late. First minister, Alex Salmond, insists that Scotland will be able to continue using the pound under a formal currency union, whilst leaders of the Labour, Conservative and Liberal Democrats remain clear there will be no currency union if Scotland votes to become independent. Whilst a currency union would likely be the best option for an independent Scotland – at least in the short to medium term – in truth it is hard to see what the rest of the UK would gain from entering into such an arrangement, particularly given the differences in size and structure of the two economies. This is clearly a critical issue. There is a significant academic literature, as well vast historic evidence, which highlights the importance of fiscal and even political union in the success of currency unions in dealing with shocks, managing crises and fending of speculative attacks.

Whilst lack of agreement on a formal currency union would not prohibit an independent Scotland from continuing to use the pound, the economic costs associated with the ‘sterlingisation’ of the Scottish economy would be high. The reason for this is directly linked to the ability of an economy to withstand shocks. Absent significant, and potentially prohibitive, capital controls, continuing to use the pound after independence would mean the complete surrender of domestic monetary policy. Monetary policy provides a vital set of tools for managing domestic imbalances, such as aggregate demand and inflation, and responding to shocks. In addition, a sterlingised Scottish economy would lose one of the most important adjustment mechanisms for the real economy – the nominal exchange rate. Whilst these issues would all still be relevant under a formal currency union, the crucial difference would be the lack of fiscal transfers.

The best remaining option for an independent Scotland would be a separate currency. The risks and uncertainties surrounding this option are numerous. On top of immediate concerns about the stability and credibility of a separate Scottish currency upon independence, are questions about natural level of the exchange rate. A separate Scottish currency would likely face significant depreciation pressures, which could have serious implications for wealth of an independent Scottish state. The most realistic scenario, certainly in the short run, would be to fix the exchange rate, perhaps within some bounds, as a means of providing some stability in relative prices. The question then is – fixed to what? One option would be simply to peg the Scottish pound (assuming the old name maintains) to the price of its main export – oil. This was initially proposed by Frankel (2005) as a desirable monetary regime for small countries reliant on a single commodity export. The idea is essentially that any shock to the price of oil would automatically deliver a real exchange rate adjustment, thus avoiding major misalignments.

What currency regime an independent Scotland would adopt is a hugely important question, and one that the Scottish Government has, at least until now, stubbornly downplayed.

More than simple economics

These are only a handful of the economic issues surrounding this debate, and the question of Scottish independence will invoke a multitude of arguments and emotions far beyond the simple question of economics. Whilst I am certainly not qualified to comment on any of these broader issues here, I would like to make one final point. In a world where the challenges we face are truly global in nature, and the consequences of failure affect each and every one of us, it can only be through increased cooperation and continued solidarity, rather than further division, that we can continue to make progress on the issues that really matter.

References

Centre for Public Policy for Regions (CPPR) (2013) “Measuring an independent Scotland’s economic performance”

Frankel, J. (2005) “Peg the export price index: A proposed monetary regime for small countries” Journal of Policy Modeling, Vol 27(4)

Hassan, T. A (2013) “Country Size, Currency Unions, and International Asset Returns” Journal of Finance

HM Government (2013) “Scotland analysis: Macroeconomic and fiscal performance”

HM Government (2014) “Scotland analysis: Assessment of a sterling currency union”

IFS (2012) “Scottish independence: the fiscal context”

Office for Budget Responsibility (OBR) (2012) “Fiscal Sustainability Report – July 2012”

van der Ploeg, F. and Poelhekke, S. (2009) “Volatility and the Natural Resource Curse” Oxford Economic Papers, Vol 61(4)

van der Ploeg, R. (2011) “Natural Resources: Curse or Blessing?” Journal of Economic Literature, Vol 49(2)

World Bank (2014) “World Economic Outlook”

Snakes and Ladders - Yemen’s Economic Challenges

I recently returned from a trip to Yemen and, having spent a fair amount of time learning about the country’s past and contemplating the many challenges and opportunities it faces, I thought I would share some of my thoughts.

Yemen is a beautiful country, with an incredibly rich history and a topography ranging from coastal planes to the west and south, to rugged mountain ranges in the interior and harsh dessert to the north. Sana’a (the capital and largest city) boasts the UNESCO world heritage site of the ‘old city’ with its unique architecture and, at an altitude of 2,300 meters, is one of the highest capital cities in the world.

The Republic of Yemen was created in a hurry in 1990 with the forced unification of the Yemen Arab Republic (North Yemen) and the People’s Democratic Republic of Yemen (South Yemen). The country has had a deeply unsettled past, characterised by colonial rule, conflict, civil unrest and has been continually buffeted by external forces and powers, often vying for influence and control over the strategically positioned territory on the Arab Peninsula.

The 2011 political crisis pushed the country to the brink of civil war and resulted in the ousting of the 32-year incumbent president Salih. As a result, the humanitarian situation in Yemen has worsened significantly: poverty has increased sharply with 55% of the population living on less than $2 a day; 10.5 million people are food insecure, and 1 million children under the age of 5 are suffering from acute malnutrition. This is a sobering reminder of the country’s complicated past and underlying economic weaknesses.

However, there is some cause for optimism. The economic challenges facing Yemen today have not changed much over the past two or three decades and are relatively well understood. There are three challenges in particular, all linked to the country’s dependence on oil which has been in steady decline since its peak in the 1990s it made up around 33% of GDP.

First, public expenditure needs to be rebalanced towards delivering public services and supporting growth and not propping up the vested interests of the elite. This must be coupled with badly needed tax reforms to broaden the tax base and reduce the reliance on the oil sector (oil income provided 63% of government revenues in 2010). The 2011 crisis highlighted these core weaknesses. Oil production stalled putting severe pressure on government revenues with the fiscal deficit reaching 7.1% of GDP ($2.8 billion) in 2011. A crisis was only just averted with the combination of Saudi oil grants and cuts to government spending. However, these cuts have been taken to public investment as well as the cash transfers budget to the poor, while the wage bill and fuel subsidies remained untouched.

Second, Yemen needs to think seriously about export diversification. Oil and gas made up 89% of export earnings in 2012, and as a result the current account is closely linked to the value of oil rents. The amount of foreign exchange reserves available to pay for imports has been falling steadily since 2002, as a result of rising import demand and declining oil production, to the point that in 2011 the country had enough reserves to cover only 4 months of imports. Had this fallen much lower, the economy may have found itself in a balance of payment crisis which would have seen Yemen unable to import basic commodities.

The third challenge is job creation. Unemployment, which stood at 15% in 2009 according to official estimates, has spiralled as a result of the crisis with youth unemployment estimated to be as high as 40%. But it is perhaps underemployment which matters more. More than 70% of Yemenis live in rural areas and the vast majority rely on small scale, low productivity agriculture for their livelihoods. This sector is particularly susceptible to seasonal weather patterns (the annual ‘lean’ season in Yemen lasts from January through to may), a worsening water scarcity situation as well as more extreme shocks (floods, droughts and storms) and would surely not be the first choice of livelihoods most of these people. According to the World Bank, over 97% of firms in Yemen are small and medium sized enterprises employing less than 25 workers. Encouraging more of these firms to invest and create more productive jobs is crucial to breaking the cycle of conflict and civil unrest.

Yemen’s future is balanced on a knife edge. March 2013 saw the launch of the National Dialogue, a process that seeks to bring together political and civil society actors to create a constitution. This process will be vital in setting the stage for a more unified country with the political leadership that can help Yemen to climb the ladders of economic prosperity. However, as the former President said himself, ruling Yemen is “like dancing on the heads of snakes”. Let us hope that there are fewer snakes than ladders.

Three false claims for austerity in the UK

Despite the IMF’s warnings, the UK Chancellor of the Exchequer, George Osborne, continues to defend his programme of fiscal tightening, worth an estimated 4.3% of GDP between 2010 and 2013. Meanwhile, the economic recovery in the UK remains weak (see chart 1 below); GDP has remained below its pre-crisis for the longest period of time since the 1920s, according to the National Institute for Economic and Social Research; and HM Treasury continues to revise downwards their forecast for UK growth (see chart 2 below).

 

Proponents of austerity often make three arguments. First, they argue that the current level of public debt in the UK is too high and bad for economic growth. Second, they worry that allowing debt to continue to rise would destroy market confidence and credibility, putting upward pressure on UK borrowing costs. And third, they maintain that increasing public spending now will inevitably lead to higher inflation in the future.

All three of these arguments in my view are false, particularly in the current UK context.

1. High levels of public debt are bad for economic growth

Of course, fiscal sustainability in the medium to long term is vital for encouraging investment and promoting economic growth. However, fiscal policy can play two other vitally important roles. First, it can support aggregate demand in the short-run and second, it can boost productivity through infrastructure investments and the provision of other public goods.

In a recently revised paper, Reinhart and Rogoff present evidence suggesting that, on average, countries with high debt-GDP ratios have slower growth than countries with low levels of debt-GDP ratios. The authors go on to state that “debt/GDP levels above 90 percent are associated with an average annual growth rate 1.2 percent lower than in periods with debt below 90 percent debt”, although this appears to be a fairly arbitrary threshold, and one could essentially choose any number and make the same statement – 10, 50, 150! This paper has been used extensively by the pro-austerity camp (Paul Ryan in his proposed “Path to Prosperity Budget” during the 2012 US presidential campaign; Olli Rehn, European Union Economic and Monetary Affairs Commissioner, in support of EU austerity) who have quoted it, completely out of context, as evidence in support of a smaller state.

However as both Brad De Long and Paul Krugman point out, this is simply a correlation and does not suggest that high levels of public debt cause lower growth. It is equally conceivable that weak economic growth reduces the level of government revenues, resulting in a rising level of public debt. In addition, even if one were to assume that the direction of causation ran from high levels of public debt to poor economic growth, the evidence from the paper suggest that the marginal effect is actually very small – De Long estimates that an increase in debt by 1% of GDP would decrease growth by a miniscule 0.06% a decade later.

Of course, what really determines the link between public debt and economic growth is what the government spends the money on. Different types of government expenditure are likely to have different impacts on economic growth both in the short and medium term. As pointed out in a letter by Robert Chote (chairman of the Office for Budget Responsibility) these ‘multipliers’ vary depending on whether the government spends on capital, welfare or public spending but that for the UK economy they are all positive, in the short-run at least. In addition, recent evidence from the IMF suggests that these multipliers may be significantly larger than we first thought – particularly during downturns.

2.    Allowing debt to continue to rise would destroy market confidence and credibility

George Osborne has consistently reminded us that excessive public sector borrowing would result in a loss in market confidence and a sharp rise in the interest rates facing the government. In a speech at Bloomberg in August 2010 he said “the actions we took in the Budget have removed the biggest downside risk to the recovery - a loss of confidence and a sharp rise in market interest rates”. Since then, net UK government debt has increased from 53.5% of GDP in 2009-10 to 75.9% of GDP in 2012-13 and is set to peak at 85.6% in 2016-17. In fact, as Martin Wolf points out, cumulative public sector net borrowing between 2011-12 and 2015-16 was forecast in the June 2010 Budget to be £322bn; in the June 2013 Budget, this had increased to £539bn. So, has this resulted in a loss of confidence and sharp rise in the cost of government borrowing? Quite the opposite in fact. 10-year government bond yields (the cost of long-term borrowing) for the UK, along with other major economies such as Germany and the US, have continued to fall steadily since the middle of 2008 and are currently at an all-time low (see chart 3 below).

Chancellor Osborne would argue that it is thanks to his unwavering resolve in his fiscal ‘plan’ that the UK government is facing record low interest rates. This is wishful thinking. The real reason government bond yields have fallen to record lows is a combination of: continued tension and uncertainty in the euro-area; a substantial programme of asset purchases (quantitative easing) by the Bank of England; extremely low interest rates around the developed world, and; the fact that investors simply know that the UK will not default on its debt.

This final point is important, and one that distinguishes the UK from its European neighbours. With full control over monetary policy and a floating exchange rate the UK has a number of other mechanisms with which to deal with internal and external imbalances, making it easier to deal with debt and to stimulate the economy. This is not the case for members of the Eurozone, for example, who can only rely on fiscal policy.

One indicator of waning market confidence was the downgrading of the UK’s credit rating from AAA to AA+, first by Moody’s in February 2013 and then by Fitch in March. However, it is important to note that both Moody’s and Fitch pointed towards a “weaker economic outlook” in the UK as the primary reason for the downgrade, and, importantly, the challenges this poses for the UK’s fiscal consolidation programme. In other words, it’s economic growth that matters, not the level of debt.

3.    Increasing public spending now will inevitably lead to higher inflation in the future

One way to think about inflation is as a function of the level of aggregate demand in an economy relative to its production capacity. When aggregate demand outstrips supply prices increase; when supply outstrips demand prices fall. In this respect, expansionary fiscal policy could lead to inflation, by increasing aggregate demand. However, given the current anaemic levels of consumer confidence and weak aggregate demand in the UK economy, the risk of runaway inflation anytime soon is almost non-existent.

More importantly perhaps, is the positive impact fiscal expansion can have on the supply side of the economy. In fact, this is the biggest advantage of fiscal policy over monetary policy. In most advanced economies, the central bank’s sole responsibility is price stability, often with some objective relating to financial stability and/or economic output. The various instruments potentially available to a central bank when conducting monetary policy – such as interest rates, the monetary base, asset purchases and forward guidance – are all designed to influence the level of aggregate demand in the short-run; not supply. Yes, supporting a well-functioning financial system does have a positive effect on firms’ output levels, but the primary objective of financial stability is to allow the economy to achieve its natural level of output and hence employment and to seek to avoid the hugely damaging effects of financial crisis.

With base interest rates at 0.5%, and asset purchases already worth £375 billion, the Bank of England has done almost all it can to stimulate the UK economy. There is clearly a potential role for fiscal policy, both in supporting aggregate demand and in boosting the productive capacity of the economy. There is an infinite list of infrastructure investments, for example, that could be made in the UK that would yield a positive real return to the UK economy. This looks even more appealing given long-term interest rates are at an all-time low.

Welcome

Welcome to Liberal Economic Musings. I created this blog as a way for me to explore some of the economic questions that I often find myself thinking about and to share my thoughts with anyone and everyone who might be interested. While the exact parameters of the blog will evolve over time, I hope to be able to write on a wide range of topics, and perhaps even get off economics from time to time. Please feel free to post comments, ask questions, and, most importantly, challenge anything you disagree with. Happy reading.