The Economic Implications of an Independent Scotland

To assess the outcome of what would occur to Scotland's trend growth in the advent of a "yes" vote in the referendum on Scottish independence due in 2014 we must look at the economic arguments that support the concept of achieving an independent Scotland; and those arguments that favour remaining in the union. No clear economic narrative exists over what would occur in the outcome of a yes vote. Under the auspices of this essay the maritime boundaries between Scotland and rest of UK (rUK) is at the 55th parallel which would see a geographical division of oil rights for Scotland, between 85 to 90% of all oil in the UK (Russell and Kelbie: 2012) which would be the United Nations definition of an independent Scotland. (UN: 1982) Thus I will only consider economic figures that take into account Scotland’s geographical share of oil revenues, as any other settlement in the advent of independence would be contrary to established international law and thus it is irrelevant to consider Scotland‘s economic figures without the oil in Scotland‘s waters.

Economic performance and thus trend growth are intrinsically linked with monetary considerations and thus we must outline what currency options an independence Scotland is faced with. (Allen: 2012)

Current Scottish Government policy is a recommendation of retaining the pound as the currency in the advent of independence. (Barnes: 2012) With Scottish exports amounting to £44.9 billion to rUK#and clear anti-foreign sentiments in regard to trade (Alesina: 2002) ensuring that a “border” does not become a barrier to the free movement and operation of trade seems sound economic policy; couple that with the strong social connections that exist within the UK; and the free movement of capital and labour between Scotland and rUK; with the internalisation of externalities as no competitive devaluations could occur between Scotland and rUK (Alesina: 2002) then that recommendation has many economic merits in its favour that may boost or not negatively impact on Scotland's trend growth.

Counter arguments to this position exist, with the main one being that with both countries expected to remain part of the European Union (EU) no trade, movement of capital and labour barriers could be put in place. (Delgado: 2007) With market integration and free trade, smaller states benefit as they enjoy the advantages of a larger market while retaining political autonomy. (Alesina and Spolaore: 2005) Scottish business having access to the larger rUK market is a reason for favouring retaining the union with rUK. (Bolton et all: 1996) The larger the market the greater the opportunity for entrepreneurs to create new niches and drive investment and subsequently growth. (Alesina: 2002) When trade is “domestic” transaction costs are lower, legal contracts created with both parties subject to the same jurisdiction share the public good of legal enforcement of contracts by national courts. (Bolton et all: 1996)

Delegation of some functions to the EU though means that Scotland would not lose the market access advantage she currently enjoys; and would be unlikely to suffer higher transaction costs if independence was to occur. The creation of multinational organisations like the EU give a clear incentive for the smaller state to be created as the viability of said state increases with economic integration across a number of states. (Alesina: 2002)

Economic integration across a wide area though needs a peaceful region; in the event of an aggressive neighbour it is self-evident that advantages lie with being a larger state so as to aid defence. (Alesina and Spolaore: 2005) In a peaceful world though the advantages lie with being a smaller state (Alesina: 2002) and in realpolitik the only threat that Scotland could face, militarily or in an economic attack, is from a belligerent England- the only country we would share a land border with. If Scotland voted to secede and England decided otherwise there is not much Scotland could do given the population disadvantage. So the only threat Scotland would face to its territorial integrity would be from rUK- which would be hard to even envision and incredibly unlikely given the social bonds and structures that exist between the states.

With the current problems in the Euro (Courtney: 2012) the creation of an independent Scottish currency could occur. With a floating currency and the ability to set interest rates at a level that more accurately reflects the needs of the Scottish Economy. Given that Scotland is a small open economy and more reliant on exports than rUK we could expect a dividend boost to our trend growth by the creation of a Scottish currency. Scotland could expect to have a weaker currency that rUK, it would depreciate against the pound and other currencies making Scottish exporters more competitive in the world economy, subsequently boosting economic trend growth, employment, productivity and government revenues; but increasing the likelihood of a problem with inflation with higher import prices in the long run. Such a policy though favours Scotland comparative advantages- rather than the current UK policies that have been accused of focusing comparative advantages of the City of London to the detriment of the other regions of the UK. The “rebalancing” of the economy- from the financial sector to a manufacturing one would be aided by a Scottish currency distinct and separate from the pound.

Increased bond yields though could cancel out this dividend as Scotland could be expected to pay higher interest rates on debt than rUK (Devlin: 15/3/2012) For the purposes of this essay then I will follow the current likely political winds of an independent Scotland retaining the pound, with the Bank of England acting as a guarantor to the country. (Castle: 2012) The nation would have complete fiscal control but would be likely subject to some constraints due to the monetary link up with rUK. (Devlin: 28/1/2012) On this basis then we could envision negligible impact of independence on Scotland’s trend growth from any monetary considerations.

Public goods costs decrease with a greater number of population. (Alesina and Spolaore: 1995) Scotland’s geography and lower population density make a compelling case for remaining in the union. Funding for Scotland already acknowledge that the costs of providing services per head of population in Scotland is higher than that of the rUK.# This bill is likely to rise if the depressing cost aspect of the larger market due to integration with rUK was to be removed. With higher government spending as percentage of GDP already prevalent in Scotland, a potential increase in government spending due to higher public goods cost may crowd out business investment as more of Scotland’s GDP flows towards the subsequent increased costs of public services. As investment is vital in long run growth; (Mankiw and Taylor: 2008) endogenous growth theory could present a problem to an independent Scotland in the long run- the potential for Scotland’s trend growth may fall with a lower investment (I) and savings (S) rate(S=I) due to the effects of crowding out. As government borrows to fund the higher costs of services, the interest rate is pushed upwards, the higher rate makes many entrepreneurial endeavours uneconomical and growth suffers accordingly. (Mankiw and Taylor: 2008)

Regaining sovereignty may see a boost in confidence and self-assurance in the people who make up Scotland though. (SNP: 2011) As Keynes outlined, confidence, though his analogy of “animal spirits” in a vital ingredient in driving entrepreneurs to seek out new investment opportunities and subsequently boost long term growth. The creation of a new state may see an increase in business activity; an economic dividend may occur for the nation due to independence that may increase the long run production frontier possibility curve due to the confidence increase raising productivity. (Mankiw and Taylor: 2008)

Administration costs and congestion costs rise as a country becomes larger. Scotland may enjoy greater spending per head than the average, but then so does London, which in 2010/11 had higher per head spending than Scotland# with a large population in a relatively small area compared to Scotland. In fact the median sized country in the world is 6 million people (Alesina: 2002) and if there were only benefits from size why not simply operate a single world government? (Alesina: 2002) While public goods may cost more per capita- choosing the basket of goods is a significant economic advantage.

The capacity to choose your own choice of public goods of the major arguments for independence, moving to one that more closely relates to the provision demanded by the populous. (Bolton et all: 1996) With perfect capital mobility in place the increased allowance in choice of preferences in a major reason for Scotland to leave the UK. (Bolton and Roland: 1997) The drive towards devolution was underpinned by this notion as Westminster was seen as not adequately reflecting the needs and wants of the Scottish people. Opinion began to form that felt that that Scotland was being pushed to the margins, especially after 18 years of Conservative rule and thus the creation of a parliament would allow greater reflection of public wants and desires. The current devolution settlement has not though afforded economic control to Holyrood; though fiscal decentralisation is a major issue, and thus full fiscal autonomy remains an option that Scotland could aspire to without fully separating from the UK.

The arguments that justify fiscal decentralisation are also applicable to the independence debate. The diversification of government spending afforded by fiscal decentralisation would allow greater accuracy in the reflection of needs of the respective regions that make up the UK. This may increase allocative efficiency as regions within a unified state have different levels of performance, the uniform provision of goods and services may overheat one area while under-funding another. (Thießen: 2003) Fiscal decentralisation allows a Pareto Improvement to occur where some regions are made better off, and no region is made worse off.

Independence though may make the element of a Pareto Improvement occurring redundant though as the mechanism for transfers that exist in a unified state between one region to another in the UK would cease to operate, taking away the insurance that Scotland enjoys being within a larger state; and potentially exacerbating the Scottish business cycle as no transfer from Scotland to other regions would occur if an exceptional period of growth was to happen. (Alesina: 2002)

Remaining in the union with fiscal autonomy though has many deficits, though transfers could still exist; the transfer from rUK to Scotland of social security payments which would still be standardised across the country would continue; but analysis of other countries experiences show that the effect of fiscal autonomy is inconclusive and perhaps negative. Spain has experienced no economic benefit to the country as a whole- only to those regions that are experiencing the autonomy. (Carrion-i-Silvestre et all: 2008) If Scotland was to experience revenue decentralisation, added to the current expenditure decentralisation that exists at Holyrood, we could expect Scotland’s trend growth to increase given the experience of Spain. (Cantarero and Gonzalez: 2009) The Italian experience has found both negative (Rodriguez-Pose and Ezcurra: 2010) and positive results though. (Tanzi: 2008; Arachi and Filippini: 2002) Beggar-thy-neighbour, a process that sees growth achieved in one region at the expense of another, could be occurring in the regions that experience fiscal decentralisation in a unified state over those who do not- perhaps explaining how the process is perhaps growth neutral for the country as a whole while beneficial for the region that attains fiscal autonomy.

The mechanism explaining how the country experiences no growth as a whole is fiscal competition- which hurts the region with higher tax as capital flight will occur. (Bolton and Roland: 1997) A federal state could overcome this problem through necessary transfers and regulation- but could the UK ever become a true Federal state? With 90% of the UK’s population domiciled in just 1 of the 4 regions a Federal UK would be to dominated and not an equal division of powers between the regions. Due to the regions straining against each other due to fiscal competition (Bolton and Roland: 1997) - any gains would be lost; perhaps reaffirming that fiscal autonomy would bring no benefit to the UK as a whole and is thus dominated by unification (the status quo) or independence. As the majority of people in Scotland are unhappy with the status quo# logically the best case for increasing Scotland’s trend growth; and the UK’s, is for the Scottish region to become independent, if the current situation must be altered. Fiscal autonomy is not a stable constitutional position if it increases Scotland’s growth at the expense of other regions of the UK.

With no transfers available from a unified state in the advent of independence then an analysis of the current expenditure and spending of the Scottish is vital to ascertaining if an independent Scotland would be viable. The current Government Expenditure and Revenues Scotland (GERS) for 2010-11 suggests that Scotland has a net fiscal balance deficit, which is when total government expenditures exceed revenues, of £10.7 billion which equates to 7.4% shortfall. On day one of independence the government would be faced with a deficit, just like most other countries in the world due to the current economic situation.

The UK as a whole, with Scottish oil revenues included (which amount to around a £8 billion windfall for Westminster in 2010#) had a budget deficit of 9.2%, £136.1 billion. At the simplest level then there is no argument blocking independence as Scotland will be just as able to afford its debts just as well as rUK is. (Bell, Guardian Press: 27/2/2012) Given that the new Scottish government would have no track record and as alluded to earlier we would expect the interest rate that the government is subject to, to be higher than the rUK. Given time though, reputation and economic performance, Scotland could see its rate achieve near parity with rUK.

Near parity with rUK in government bond yields is made more likely by an analysis of Scotland’s likely share of the national debts. With current UK national debt standing at £988.7 Billion (63% of GDP)# (FEB 2012 FIGURES) - and by a per capita share of debts allocation; 8.4%# of said debt would be Scotland's, resulting in Scotland having a government debt of £83.05 Billion on day 1 of independence (if it was to occur FEB 2012). The GDP of Scotland in 2010 was £142 billion# (when all activity occurring in Scotland's waters is taken into account. Leaving the Scottish government with a debt/GDP ratio of 58.4%- lower than the equivalent rUK debt liability. In the long run though would Scotland be able to continue to fund the social security benefits that she enjoys from the transfer from rUK- which currently equates to roughly to a level equal to the deficit of Scotland. (Redwood: 2012)

If the same level of social welfare provision was to continue it would be very difficult to envision Scotland closing the structural deficit currently in operation. Reducing payments and provision would have to occur in the long run to ensure growth. With Scotland’s budget constraint becoming “hard” in the advent of independence financial realities may force any Scottish governments hand; meaning that there is a significant chance that the provision of the welfare state could be reduced in a “yes” vote, unless a significant economic growth boom, and subsequent increase in government revenues, were to occur. This is made more likely if we remain in the pound currency area as we would be unable to “inflate” our debts and government obligations away.

Even with the relative health of Scotland's fiscal position as compared to the UK's; significant fixed costs would occur in the initial period that may impact on services and the Debt/GDP ratio. The creation of embassies; adjustment costs in the creation of a specific Scottish body for services that are currently provided pan-UK, for example the DVLA, the military, health and safety regulators etc. Given the experience of other nations who have sought independence compromises could and have been reached to minimise the costs- such as Serbia and Montenegro sharing some embassies even after the independence of Montenegro in 2006.# It is likely such a scenario would occur with UK assets on a per capita division basis.

The dependence of Scotland on one source of revenue, oil and gas, is a worrying aspect of independence. Making up around 12% of an independent Scotland’s government revenues the volatility of the commodity in terms of price; and in production; with the future decrease in production with UK “peak oil” being reached in 1999- and yields falling on average 6.2% a year; coupled with future high decommissioning costs (Economist:18/2/2012) means that an independent Scotland’s trend growth is perhaps too overtly reliant on a commodity that will not last forever. A long transitional period so that new sectors may emerge in the Scottish economy is possible though, especially if the high price of oil remains; Wälde (: 2003) which has already made unprofitable reserves feasible and production may continue at a significant level for the next 40 years. (Miller: 2008) If the crisis in Iran does not flare up analysts expect the price in the next decade; the first decade of an independent Scotland; too fall due to the drops in demand.# If Iran does become an issue; and war likely; the price of oil could soar to heights unprecedented, with the IMF forecasting at least a 30% rise in price# and the price would remain stubbornly high for the next decade. Even a rise at this level though the SNP’s plans for a £90 billion# oil fund are perhaps unrealistic. An independent Scotland would need to meet current spending requirements from oil revenues to replace the amount of money received in transfer payments from rUK.

What new sectors could emerge to replace oil and gas? Much political capital and scope has been placed into the Renewable energy sector. (Aardvark: 2012)) Analysis of this sector has shown that Scotland receives a net transfer from the rUK of £330 million (2009/10) (Marsh and Miers: 2011) to support the new sector- a figure that is rising each year. As outlined earlier these transfers would cease in the event of independence; and could perhaps jeopardise the creation of a Scottish economy based on “green credentials.”

How Scotland’s trend growth is affected by independence is a hotly contested issue; with nationalists and unionists currently developing new arguments daily; sometimes being economical with the truth; and suggesting that current political issues and news stories somehow have a bearing on the long term future for Scotland. In reality though- no one can make a conclusive case for Scotland’s growth being positively or negatively affected by independence. What is clear that Scotland’s budget is roughly balanced- the money that an independent Scotland would gain from oil revenues roughly equates to the social welfare transfers that she receives from rUK. It’s likely that independence will not be the panacea that many nationalists hope for- heralding an age of prosperity for Scotland. It also will not be the disaster that unionists claim.

Small open economies that are driven by exports benefit from having control over their own affairs and choice of public good provision though. Remaining in multinational organisations such as the EU means that raised transaction costs and being subject to trade barriers with our largest export partners is not a fear. Fiscal competition and the experiences of other countries show that if you are going to move away from the unitarily state- independence dominates autonomy. The UK could never become an equal federal state like the USA; it would resemble the USSR and Yugoslavia with one dominant power- Scotland and England joined together in 1707 as equals- the state was explicitly designed to be unitary not federal. “Devolution-max” which is fiscal autonomy would raise Scotland’s trend growth, but only at the expense of the other regions in the UK- which is unfair and not a long term solution.

Personally this author errs on the side that a small economic benefit will be derived from independence; especially if the country was to create its own currency. Remaining in monetary union with rUK seems economically sound, but politically unappealing. And that is the crux of the argument- as much as the Scottish people will claim that they follow the economic arguments they will not vote in 2014 over such technical issues such as trend growth, monetary relationships, control over aggregate demand- they will vote with their hearts, their minds, be influenced by their peers, be susceptible to the influence of culture and by the arguments of the politicians. The economic arguments for political independence are complex, and are so compelling as there remains no definitive answer.

References

Aardvark, Tony. (2012) “Wind Power – Scotland’s Role As The Saudi Arabia Of Renewables, Or Not” Tony Aardvark Blog.
http://toryaardvark.com/2011/02/28/wind-power-scotland%E2%80%99s-role-as-the-saudi-arabia-of-renewables-or-not/

Alesina, A. (2002). “The Size of Countries: Does it Matter?” Harvard Institute of Economic Research. Discussion Paper Number 1975 (1)
http://www.economics.harvard.edu/pub/hier/2002/HIER1975.pdf

Alesina, A. and Spolaore, E. (1995). “On the Number and Size of Nations.” NBER Working Paper. 1 (Working Paper 5050), 1- 47.
http://www.nber.org/papers/w5050.pdf

Alesina, A. (2010). “JOSEPH SCHUMPETER LECTURE THE SIZE OF COUNTRIES: DOES IT MATTER?” NBER and CEPR. 1 (2-3), 301-316.
http://onlinelibrary.wiley.com/doi/10.1162/154247603322390946/pdf

Allen, Katie. (28/2/2012) “Can Scotland be independent and keep sterling?” Guardian Press.
http://www.guardian.co.uk/news/reality-check-with-polly-curtis/2012/feb/28/can-scotland-be-independent-and-keep-sterling

Arachi, G., and Filippini, C., (2002) “Fiscal Decentralisation and the Autonomy of the Local Governments in Italy.” University of Lecce Department of Economics Working Paper No. 16/8.

Ball, Jamie. (27/2/2012) “How much debt would an independent Scotland have?” Guardian Press.
http://www.guardian.co.uk/politics/reality-check-with-polly-curtis/2012/feb/27/scotland-independent-debt-deficit

Barnes, Eddie. (2/2/2012) “Independent Scotland to stick with sterling.” Scotsman.com.
http://www.scotsman.com/news/independent-scotland-to-stick-with-sterling-1-2090953

Bolton, P and Roland, G. (1997). “The Break-Up of Nations: A Political Economy Analysis.” The Quarterly Journal of Economics. 112 (4), 1057-1090
http://qje.oxfordjournals.org/content/112/4/1057.full.pdf

Bolton, P. Roland, G. and Spolaore, E. (1996). “Economic theories of the break-up and integration of nations.” European Economic Review. 40
http://www.sciencedirect.com/science/article/pii/001429219500081X

Cantarero, D., and Gonzalez, P.P., (2009) “Fiscal Decentralization and Economic Growth: Evidence from Spanish Regions.” Public Budgeting & Finance, Vol. 29(4), p. 24-44.

Carrion-i-Silvestre, JL., Espasa, M., and Mora, T., 2008. “Fiscal Decentralization and Economic Growth in Spain.” Public Finance Review. vol. 36 (2), p.194-218.

Castle, Tim. (25/1/2012) “Solo Scotland would expect BoE backing – Salmond” Reuters Press.
http://uk.reuters.com/article/2012/01/25/uk-britain-scotland-banks-idUKTRE80O01F20120125

Courtney, Siobhan. (23/1/2012) “Does Scotland want a divorce?” Al Jazeera.com
http://www.aljazeera.com/indepth/opinion/2012/01/20121211310377835.html

Delgado, Juan. (2007) “New Challenges of the EU Single Market.” Bruegel – DG Internal Market workshop "The economic policy for the Single Market of the future."
http://ec.europa.eu/internal_market/strategy/docs/bruegel/jdelgado_en.pdf

Devlin, Kate. (28/1/2012) “Scots budget veto threat to Bank of England plan” Herald Scotland.
http://www.heraldscotland.com/politics/political-news/scots-budget-veto-threat-to-bank-of-england-plan.1327719989

Devlin, Kate. (15/3/2012) “Independent Scotland 'would lose its triple-A status’” Herald Scotland.
http://www.heraldscotland.com/politics/political-news/independent-scotland-would-lose-its-triple-a-status.17027236

Economist. (18/2/2012) “Roll on the barrels” Economist Press.
http://www.economist.com/node/21547791

Marsh, Richard and Miers, Tom. (2011) “Worth the Candle? The Economic Impact of Renewable Energy Policy in Scotland and the UK” Verso Economics.

Mankiw, Gregory N. and Taylor, Mark P. (2008) “Macroeconomics European Edition” Worth Publishers; 6th edition

Miller, Hayley. (4/6/2008) “Oil reserves 'will last decades'” BBC NEWS.
http://news.bbc.co.uk/1/hi/scotland/7435016.stm

Redwood, John. (2012) “The UK transfer union” John Redwood Blog.
http://johnredwoodsdiary.com/2012/02/17/the-uk-transfer-union/

Rodríguez-Pose, A., and Ezcurra, R., (2010) “Is fiscal decentralization harmful for economic growth? Evidence from the OECD countries.” Journal of Economic Geography, 11(4), p. 619-643.

Russell, Ben and Kelbie, Paul. (9/12/2005) “How black gold was hijacked: North sea oil and the betrayal of Scotland” The Independent.
http://www.independent.co.uk/news/uk/this-britain/how-black-gold-was-hijacked-north-sea-oil-and-the-betrayal-of-scotland-518697.html

SNP. (2011) “SNP Manifesto” Election Literature for 2011 Election.
http://votesnp.com/campaigns/SNP_Manifesto_2011_lowRes.pdf

Tanzi, V., (2008) “The future of fiscal federalism.” European Journal of Political Economy. 23(3), p. 705-712.

Thießen, U. (2003) “Fiscal Decentralisation and Economic Growth in High-Income OECD Countries.” Fiscal Studies. 4(3), p. 237-274.

Wälde, Thomas, W. (2003) “Scotland's Oil: Does oil in Scotland have a future?” The Centre for Energy, Petroleum and Mineral Law and Policy Internet Journal. Dundee University. Volume 14, Article 10.
http://www.dundee.ac.uk/cepmlp/journal/html/Vol14/Vol14_5.pdf

UN. United Nations Convention on the Law of the Sea of 10 December 1982
http://www.un.org/depts/los/convention_agreements/convention_overview_convention.htm