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The economics of aye or nay

Posted on August 01, 2014 by Tom Healy

Tom Healy, Director NERI
Tom Healy, Director NERI

Adam Smith, a Scottish political economist and philosopher of the 18th century is famous for having written The Wealth of Nations. He is less well known for having written an important work entitled The Theory of Moral Sentiment. The latter work is a very important contribution to moral and political economy.  The outcome of the referendum on the proposed political independence of Scotland on 18th September will be decided on a range of inter-linked concerns and drivers including political, cultural, moral and economic. This blog focuses on the questions raised under the latter – economic – even though ‘economic’ can never be viewed as entirely self-contained and separate from the moral, political and cultural.

Ties of history, overlapping of institutions and established flows of trade and population define a complex interaction within and between these two large islands to the North West of Europe. Geographically on the periphery of Europe, the islands have had a difficult, and at times, troubled history. But they have managed to carve out a significant place in economic history as drivers of change, technological innovation and trade.

Clearly, independence or some form of further devolution of powers to the Scottish Government is a matter for the Scottish people. Unlike county Kerry and the shire/county of Sussex, Scotland as an entity has been given the right to secede from its larger belonging. The economic implications for Ireland – North and South – are significant not to mention those for Scotland, England and Wales. Even if independence is accepted in next month’s referendum it will be March 2016 before it would take effect.

There is a self-evident rationale for cooperation and sharing of resources where location, technology, geography and political factors permit it. For example, the island of Ireland is a ‘natural’ unit when considering the requirements of a modern and fast-changing market for energy – renewable or otherwise. Likewise, geographical proximity together with sharing of language and broad similarity in legal institutions and common law provide a basis for closer cooperation between both islands of Ireland Great Britain. The nature of this cooperation has changed with political developments over time as well as the ever closer integration of both islands in the European Union which has created an impetus towards a single market for goods and services and standardised regulations in many areas of economic life (even if the United Kingdom has opted out of some of these). Driving from Dundalk to Newry, these days, is not significantly more remarkable than driving from Glasgow to Carlisle (apart from slightly different road signs and the use of Kilometres in the Republic of Ireland). Changing to a different currency is a nuisance and entails costs and risks to businesses and individuals but it is manageable. Consideration of the possibility of Scottish independence should be viewed in this new European context. Borders are not what they used to be (at least within the European Union but often with neighbouring jurisdictions as a result of the European Economic Area and other agreements).

Some economic arguments for independence

What are the economic considerations in regards to the independence proposal? The case for is outlined in the Scottish Government’s White Paper Scotland’s Future. In this paper the prospects are offered, under independence for such outcomes as better public services, return of Royal Mail to public ownership, and an end to the ‘Bedroom Tax’ in Scotland. The Paper also envisages a reduction in the Corporate Tax rate ‘by up to three percentage points to counter the gravitational business pull of London’. The White Paper draws attention to the strengths of Scotland’s economy in regards to natural resources, services, exports and a skilled workforce. It is argued that these resources and opportunities can be better put to use under an independent political settlement. In terms of international comparison the White Paper refers to other small European countries and mentions the Nordic countries in particular with the implication that an independent Scotland is more likely to adopt economic policies favourable to distribution, public service and innovation. It is estimated, in the White Paper, that tax revenue per head of population is higher in Scotland than in the rest of the UK.

North Sea oil and gas

Revenue flows from gas and oil off the coast of Scotland are a significant factor in the debate. These are large but set to decline over coming decades. The share-out of these revenue flows between Scotland and the (residual) UK is not certain.

Cross-border trade

The Conclusions of the Scotland Analysis report produced by the UK Government (which is against independence) states that trade between Scotland and the rest of the UK is greater than exports by Scotland to the world outside the UK. As in Northern Ireland, energy and other costs are spread across the much larger economic entity of the UK. This probably tends to reduce costs somewhat compared to an alternative arrangement. An alternative pro-independence perspective on economic issues is provided on the Scottish Government’s website here. Its key economic argument in regards to fiscal policy is as follows:

Just like any other independent country, the future path for Scotland’s fiscal position will depend upon the policy choices of successive Scottish administrations. Successful economic policies which boost productivity, grow Scotland’s working age population and increase participation in the labour market will strengthen the public finances.

Banking and financial services

Uncertainties about currency, trade and cross-border business (see references to the EU below) are cited as reasons to be cautious about a movement to full independence. We simply don’t know what will happen, how and when. Scotland joining the Euro might be an option but far from simple. Joining the Euro would expose Scotland to the same disciplines, risks and opportunities as the Republic of Ireland. In its current state the Euro currency and banking system is hardly fit for purpose although intentions and plans to reform and strengthen the governance architecture might help greatly.

Currency choices

Maintenance of sterling (or parity with Sterling such as applied in the Republic of Ireland up to 1978) might be another option but could entail significant continuing lack of sovereignty especially in regards to monetary policy (as would membership of the Eurozone).

Aside from the currency question, vulnerability to financial and banking shocks (such as in the case of the Republic of Ireland which cost around one third of annual GDP and opened up an exposure to guaranteed bank debt of double annual GDP) is cited by sceptics especially in the context of a large financial sector in Scotland (the Royal Bank of Scotland is headquartered there). Mark Carney, the Governor of the Bank of England (the UK Central Bank) in a speech last January reports an estimate of total bank liabilities equal to 12.5 times the size of Scottish GDP in 2012 (compared to 7.1 in the Republic of Ireland).

Devolution of tax and public spending powers

Scottish discretion to adjust taxes (downwards) and public spending (upwards) is seen as a positive. Much will depend on the extent of devolution granted (under a ‘No’ vote scenario) as well as the political make-up of a Scottish administration. Generally, Scottish voters have traditionally opted for more left-of-centre parties. However, EU rules (were Scotland to be part of the EU in a independence scenario) will place restrictions on the extent to which government deficits and debts can be used in the economic cycle.

The extent of the net fiscal transfer from Westminster to Scotland is disputed territory due to the way North sea oil and gas flows are accounted for. It is clear, however, that Scotland is currently a net fiscal recipient when North Sea oil and gas are taken out of the equation while the projected Government deficit in 2016/17 is in the order of 5% of Scottish GDP. A paper by Paul Johnson and David Phillips for the Institute for Fiscal Studies in the UK (IFS)

Like the UK as a whole, and most other developed nations, an independent Scotland would face some tough long term choices in the face of spending pressures created by demographic change. If, as is likely, oil and gas revenues fall over the long run then the fiscal challenge facing Scotland will be greater than facing the UK.

In a research paper (Assets and Liabilities and Scottish Independence) by the UK National Institute of Economic and Social Research (NIERSR) economists Armstrong and Ebell write:

We estimate that Scotland would need to run primary surpluses of 3.1% annually order to achieve a Maastricht defined debt to GDP ratio of 60% after 10 years of independence. This would be more restrictive than the fiscal tightening over the last four years.

Armstrong and Ebell also model the impact of independence (using a ‘clean break’ and separately an ‘IOU’ scenario) to find that gross and net public debt in the UK would rise significantly under both scenarios with possible implications for credit rating of the UK.

An independent Scotland would need to cut public spending or raise taxes (generating revenue-friendly growth is, of course, an additional complementary option). Even left-of-centre parties are reluctant to countenance tax rises – especially these days as the battle for the political middle ground is often fought on promises to deliver ‘excellent public services’ more efficiently with lower taxes on most of the population (or everyone). Reality and promise usually collide after elections.

Whatever the outcome on 18th September it is clear that further devolution of political powers to Scotland from Westminster is on the table. This will have implications for decisions on taxation and public spending among other factors. The ‘Barnett Formula’ by which the UK Treasury adjusts public expenditure in Scotland, Wales and Northern Ireland to reflect changes in spending allocated to public services in the rest of the UK is likely to change. This could have big implications for Northern Ireland where ‘net fiscal transfers’ (the difference between estimated total public spending  and estimated total public revenue from Westminster to the Northern Ireland Executive is approximately one third of regional GDP (as measured by Gross Value Added). Transfers of this magnitude are not unusual in many larger federal and non-federal European economies.

The EU

One of the big economic unknowns is how a referendum result in Scotland next month will interact with an outcome in a UK-wide (with or without Scotland) vote on the European Union in 2017.  A Johari four-window of possible outcomes could be constructed. In a research paper (‘Scotland’s vote on independence: the implications for Ireland’) for the International Institute of Economic affairs in Dublin (IIEA), Paul Gillespie reviews four different scenarios and their possible (political) implications:

  1. UK stay in EU+Scotland stay in UK
  2. UK leave EU+Scotland stay in UK (but with the prospect of more devolved powers)
  3. UK stay in EU+Scotland leave UK
  4. UK leave EU+Scotland leave UK

Each of the above scenarios is likely to have significant long-term economic and political implications for both Northern Ireland and the Republic of Ireland. The 4th scenario, according to Gillespie, could be particularly significant.

The case of the Irish Free State post 1922

The benefits of strong national sentiment and fiscal autonomy have been mentioned as positives. References have been made to the success of the Republic of Ireland in terms of inward investment, education and export performance (although these references were more frequent during the time of the Celtic Tiger). However, the Republic of Ireland (or Irish Free State) is difficult to compare with Scotland (see below).

Indeed, any move to full independence on the part of Scotland would raise questions about when and how it might be part of the European Union post-independence. There is no script or precedence for this type of situation. As in any divorce settlement – no matter how pleasant – assets and liabilities need to be divided up. Estimation becomes crucial and there is no formula to hand. A paper by McLaughlin and Foley-Fischer (‘Irish Land Bonds, 1891-1938’) estimates that the new Irish Free State was required to take on a portion of UK national debt including Land Bonds following land reforms in the 19th century. The negotiation and actual working out of these debts for two decades following independence was not easy or straight forward. McLaughlin and Foley-Fischer estimate that Land Bonds, alone, accounted for approximately 40% of GDP in the Irish Free State at the time of independence and peaked at an estimated 60% of GDP in the early 1930s when the then incoming Fianna Fáil Government defaulted on land annuities. The Government of 1922 was liable for four public debts: Irish Republic Bond-Certificates (issued to fund the War of Independence); Land Bonds; a share of Imperial Debt; and new issuance. (The Imperial debt component was excused in 1925)

The experience of the Irish Free State in 1922 does not provide a huge lot of useful historical material given the distance in time and the very different conditions under which the 1921 Anglo-Irish Treaty was adopted. Yet, some interesting parallels are apparent including the unique relationship with Sterling up to 1978 and the absence of an effective independent monetary policy in the Irish Free State/Republic of Ireland (from 1948) for many decades following independence. Scotland 2014 is not comparable with the Irish Free State of the 1920s  - the latter being heavily reliant as it was on agriculture, badly damaged by civil conflict, orientated towards British markets and very under-developed economically. The new Free State consisted of a ‘small, late-industrialising, peripheral economy with a long-standing labour surplus’ as Kennedy, Giblin and McHugh noted in their ‘Economic Development of Ireland in the Twentieth Century’ (1988). This is not a meaningful comparator for modern-day Scotland. They concluded, nonetheless, that Irish independence had, probably, increased output and employment more than it would have been had all of Ireland remained in the UK but living standards might have been higher and population somewhat lower as a result of fiscal transfers from Britain. Clearly, the pre-independence promises and expectations were not fully realised in the decades immediately after independence. As in many areas of life the outcomes are varied and expectations and hopes are not fully realised. But, on balance it seems that Ireland (south) gained and, at the same time, managed to retain a parity link with sterling albeit under very different world conditions to what now prevails.

The question of EU norms and arrangements arises. There are, for example, significant differences between Scotland and England in regards to the treatment of student fees in higher education. These would be untenable if Scotland and the (residual) UK constituted two separate members of the European Union (because one Member State cannot discriminate against another Member State). Full accession by Scotland to the EU would be based on an application process in which EU Member States would be required to ratify any application for membership by Scotland. In the event of a breakup of the UK followed by a ‘Brexit’ post 2017 (an exit by the UK from the EU) there would be a period of negotiation which might be lengthy and fraught.

The impact of a ‘Yes’ vote would be such as to increase political and economic uncertainty at least for a number of years.  Longer-term benefits could flow from a greater sense of confidence and empowerment in Scotland. This could spill over, favourably, on Northern Ireland. However, it is also possible that independence could expose Scotland to external and internal shocks more than before with adverse effects for its neighbours. Data on the extent and composition of trade between Scotland and Northern Ireland/Republic of Ireland are not available. Some impact will be felt in sectors with traditional linkages in manufacturing or business services.  A movement to greater autonomy (regardless of the outcome of the referendum) is likely to give renewed impetus to calls, in Northern Ireland, to further cut corporate tax rates while leaving the Republic additionally vulnerable in the international competition for inward investment.

Is there an economic bottom line?

It is difficult to prove a clear advantage or disadvantage, economically, for Scotland under independence. Independence, if it were adopted, would entail greater economic and political risk and uncertainty. But this risk and uncertainty could prove successful in the long-run (as well as the short-run). As with other small European States, an independent Scotland would have the advantage of punching above its weight internationally and opening up new economic possibilities while being exposed to greater risk especially if further international shocks were looming. But, the outcome will not be decided on economics alone and ‘moral sentiment’ not to mention national (in either direction) might prevail over a hard-headed calculus of the nation’s wealth risks. Then again, it might not! Homo economicus whether in Scotland or anywhere else in the world has attachments, loyalties and feelings when making rational economic choices!

One thing is certain – we live in interesting times.

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