Thank you for this invitation to speak at the Scotsman conference on the Economics of Independence. Like Angus, I am one of the research fellows appointed by the ESRC to study issues relating to the constitutional future of the UK and Scotland. Angus and I particularly focus on the economic issues and we have spent some time discussing how these may evolve should Scotland opt for independence after the referendum in 2014.
Let me begin by taking you back to some historical events [SLIDE 2].
In 1695, the Company of Scotland started to collect subscriptions for colonial ventures. It raised the equivalent of a fifth of the wealth of Scotland and embarked on an ambitious plan to establish colonies around the world. Unfortunately, it fell under the influence of William Paterson, who later founded the Bank of England, but who persuaded the investors to focus on a single project in the Darien Peninsula in South America. The venture was a disaster, particularly in financial terms and indirectly led to the Act of Union. Support for the Union of the Parliaments in 1707 came from many of those Scots who were compensated (paid off) for their losses by the UK Treasury. The 1707 Union also led to a currency union, one of the key issues in the current debate. Specifically, Article 16 of the Treaty of Union 1707 states:
XVI. ‘That, from and after the Union, the Coin shall be of the same Standard and Value throughout the united Kingdom, as now in England’
What came with the currency union was, of course, an almost complete fiscal union.
So Scotland’s economic problems at the beginning of the 18th century precipitated a change in its constitutional settlement. The course of events also demonstrates the dangers of a small country, with fewer options than a large one, failing to spread risk. And finally it shows that many of the economic arguments about the costs and benefits of independence such as currency and fiscal union have historical precedents.
Switching forward to 1979, there was no constitutional change after the referendum of that year even though the number of “yes” votes exceeded the “no” votes. This was again a period of economic difficulty, particularly for parts of the UK like Scotland, where the economy was still industrially based. Loss aversion played an important part in ensuring that the pro-devolution campaign did not succeed.
However, if a new nation state needed to establish financial credibility by demonstrating an ability to control its public finances, there never was a better time for Scotland to have sought independence. Whereas the state of UK finances was parlous throughout the 1970s, it was rescued by North Sea oil during the 1980s [SLIDE 3]. Scotland ran a significant budget surplus throughout most of the 1980s if one attributes a geographical share of North Sea oil revenues to Scotland. Had Scotland been independent then, this period could have been used to establish an oil fund which would certainly have enhanced Scotland’s credibility in financial markets. But bygones are bygones.
For those seeking independence, another opportune time might have been 2004 [SLIDE 4]. Then, the U.K.’s debt to GDP ratio was around 40%, significantly lower than many other major industrialised countries. The costs of servicing the debt were correspondingly low. Had Scotland become independent in 2004, it would have inherited a relatively low level of debt which would have boosted its capital market credibility. But the boost might only have been temporary. I suspect that in 2004, no Scottish government would have wished to see RBS move its corporate headquarters to England. So it might have had some interesting challenges in the first few years of its existence, assuming it failed to rein in the RBS balance sheet.
Now move on to 2014 and consider the economic environment within which the referendum will be framed. Since 2008, UK finances have worsened. Whereas Germany and Canada have managed to stabilise their public debt, the national debt in France, the UK and the USA will be around 110% of GDP in 2014. If, as one would expect, an independent Scotland has to take a share of this debt close to its population share, it would face significant ongoing debt-servicing costs. Using the population share allocation, debt interest payments in Scotland 2007-8 would have been £2.7 billion. By 2011-12, this would have risen to £4.1 billion – around 7% of Total Managed Expenditure. This is based on UK long-term rates, which are currently around 1.9 per cent. Most small countries in Northern Europe have similar or slightly lower rates, though Ireland is a significant exception.
Voters’ opinions in 2014 will undoubtedly be influenced by the state of the world outside these shores. The events of the last five years, particularly in the Eurozone, show that fiscal and currency instability have not been consigned to the dustbin of history. Greece, Spain and Ireland are perhaps the most extreme cases, but the economic malaise that has spread more generally across Europe may make Scottish voters less willing to take risks.
The anxiety regarding the Eurozone is widespread. The noted macroeconomist, Paul De Grauwe writing about the Eurozone recently concluded that “Economists have long recognized that ultimately the monetary union will have to be embedded in a fiscal union. Put differently, the euro is a currency without a country. To make the euro sustainable a country will have to be created. An essential component of a country is a central authority capable of raising taxes and to spend for the whole of the union.” An alternative to complete fiscal union, suggested by the Padoa-Schioppa group (2012) has suggested a gradual loss of control over their national budgetary process for the countries that fail to abide by budgetary rules. As Angus has implied designing enforceable fiscal contracts has proved well-nigh impossible thus far.
De Grauwe also argues that a banking union is necessary for the eurozone. He cites two reasons. First, since the ECB is the lender of last resort for the Eurozone banking system, the regulation and the supervision cannot be kept at the national level. Second, a banking union circumvents the “deadly embrace” between sovereign and banks which has, for example, laid waste to the Irish economy.
Given that the forces of economic convergence are probably at a zenith in Europe at present, the timing of the Scottish referendum could hardly be worse for those promoting independence. The viability of currency unions is under the most intensive scrutiny and the conclusions suggest that other structures such as fiscal and banking unions need to be in place if currency unions are to survive.
Now consider Scotland’s current fiscal position.
The data suggests that at least in the short to medium term, post-independence Scotland will have difficulty in achieving fiscal balance. The same is true of the UK. In fact, the UK as a whole has a larger fiscal deficit than Scotland, so long as a geographical share of North Sea Oil revenues is attributed to Scotland. In the UK as a whole, net borrowing stood at 11.2 per cent of GDP in 2009-10; it fell to 7.9 per cent in 2011-12 and has since stalled. Scotland by contrast, taking account of North Sea oil, had a deficit of “only” 5 per cent of GDP in 2011-12.
In 2011-12 Scotland raised £56.9bn in taxes (including the North Sea), but spent £64.5bn on public services. An independent Scotland could reconfigure its public services to bring its budget closer to balance. It could for example choose not to spend any money on defence – this would save it £3.3bn – but this would not fully close the gap. Any such savings would come at a political cost.
However, the size of the deficit matters less for the UK as a whole than it would for a newly independent Scotland. The UK has market credibility and an infrastructure to support large-scale government borrowing. Scotland does not. These would have to be established immediately following independence.
As mentioned earlier, Scotland will also have a relatively large debt. The March OBR forecast was that net debt in the UK would reach £1637bn by 2017-18. On a population share basis, Scotland’s share of this total would be around £137.5bn. As Angus has commented, this would also form part of the market’s assessment of Scotland’s creditworthiness. [SLIDE 5]
As recent international experience has shown, the markets will extract a high price from less creditworthy borrowers. Countries with robust growth are better risks: countries with public spending under control are better risks; countries that have avoided banking sector meltdown are better risks. Countries with a long track record of paying their debts and with sophisticated capital markets are also thought less risky by the markets. It is on this last characteristic that the UK wins out relative to an untested Scotland.
How much would the Scottish economy have to grow to offset last year’s deficit? In the long run, tax revenues rise at around 0.35% of GDP for each 1 per cent of growth [SLIDE 6]. This would imply that Scottish GDP would have to rise by around 14% to fully offset the current deficit, holding public spending fixed. Clearly, this might occur over some period of time and it would be unlikely that the markets would require Scotland to achieve fiscal balance. Key to this would be market patience with Scotland’s rate of fiscal consolidation.
If the Scottish economy could not generate sufficient growth, fiscal adjustment would be required. My final slide [SLIDE 7] shows the 2011-12 calculations of public spending and taxation in Scotland arranged in order of size. It shows magnitudes, but does not particularly help in assessing how spending and taxes could be adjusted at minimum social cost. It shows, for example, that social protection, which comprises old age pensions and welfare payments, costs more than income tax and North Sea oil revenues combined. Both of these revenue sources have been highly volatile in recent years while most forward projections suggest there will be considerable upward pressure on the social protection due to demographic change. Nevertheless, as stated above, these pressures will be much reduced if the economy can return to its previous trend levels of growth.
To conclude, the contents of this slide comprise the main subject area of my fellowship – looking at patterns of spending and taxation in Scotland: considering how these affect the efficiency of the Scottish economy and how they impact on different groups in Scottish society – which will be the subject of further presentations and papers.
 De Grauwe, P. (2012) Design Failures in the Eurozone: Can they be fixed? LSE ‘Europe in Question’ Discussion Paper Series