Thursday, 9 February 2012

The Economics of Independence

I don't know, but perhaps the expectation that there are "tremendously negative economic consequences for Scotland" with independence, is the mainstream view? [Quote from an international MSc Economics student]. Is this a reasonable view? Let's analyse this from both short run and long run perspectives.

In the short run surely the most relevant way to answer the question is to take Scotland's capital stock and productivity as given and look at its current fiscal and external position relative to the UK as a whole. The fiscal position according to the latest GERS report (see p26) is that Scotland was running a net fiscal balance deficit of 10.6% in 2009-10 relative to a UK net fiscal balance deficit of 11.1%. So whilst neither Scotland nor the UK have particularly healthy public sector finances, the current situation reflects a small fiscal transfer (approximately 0.5% of Scottish GDP) from Scotland to the rest of the UK (this includes a geographic share of North Sea oil revenues).

Scotland's external position, its trade deficit, is in a similar position: it's not great, but it's not quite as bad as the position of the UK as whole (again taking the North Sea into account). The other short run indicator we might look at is productivity, here again Scotland does relatively well as the third highest ranked region of the UK in GVA per capita terms (after Greater London (which to be fair is way out in front), and SE England). The short run position then is fairly clear. Whilst independence could be associated with some transaction costs (in the main these will be job creating transaction costs since they will be incurred due to the fact that some functions of government have to be created here), the fiscal, external and productivity positions suggest that the economic situation would be broadly unchanged.

The other issue that impacts on the short run, but also on the long run, is monetary policy. The eurozone crisis has highlighted the risks of monetary union without fiscal integration - which given the stated policy of keeping Sterling initially, looks like an economic cost of independence. However, as Martin Wolf at the FT (and others) have pointed out, the best predictor of difficulties within the eurozone was balance of payments problems, where at a fixed price (exchange rate) the peripheral nations were net importers of goods and services funded by capital flows from the core. Scotland is not in this position: our economy is 'pre-adjusted' to this fixed exchange rate, and there are not massive balance of payments imbalances. Eventually, with policy divergence, this currency arrangement may no longer be appropriate. However, by then we will have a government with the power to change it and either join a reformed supranational currency area (Sterling or Euro) with transfer payments, or start a Scottish currency.

This brings us on to the long run. Energy resources and a favourable long term climate situation, as well as other advantages like a strong university sector and ownership of the Scotch label for putting on bottles of whisky(*) suggest that Scotland has the resources to prosper in the long term, at least as well as any other country of similar size. But what about the effects of being part of a country of 5 million relative to being part of a country of 60 million?

Economic theory, in the main, is pro free trade and the regime in which trade is free-est is within a single state/regulatory area. This theory underpins international moves towards globalisation, reductions in trade barriers and the creation of the EU and NAFTA etc. Two important contributions to these theories are increasing returns to scale, and a survival of the fittest mechanism that leads to only the more efficient firms surviving in larger economies. Both these mechanisms have a persuasive appeal and probably apply to some extent. However, if they were the dominant effects then we would expect to see a systematic effect of larger countries being wealthier than smaller countries. We do not see this relationship which suggests that there must be offsetting benefits that come with being small.

My favourite mechanism by which Scotland could benefit economically from independence is to do with agglomeration and increasing returns to scale. Currently I think that large UK companies are 'agglomerating' head office functions in London to realise economies of scale. This may produce some private efficiencies, but it has social costs at the level of the lifestyles that it imposes upon the workers in London (2 hour commutes for City workers, impossible living costs for public servants, and monopoly rents paid to landowners) and at the level of career opportunities that it leaves for people outwith London (move to London or never reach the top). I believe Scottish independence could lead to some companies 'agglomerating' their head office functions near policymakers in Scotland, so that we have a self-sustaining business ecology here too.

There are other arguments that follow from analogy with ecology, for example: multi-polar centres of power, or a diversity of localities with political and economic power, could lead to a diversity of opinions and strategies. In the same way as genetic and species diversity leads to robust ecosystems, a diversity of economic strategies, policies and companies is more likely to lead to a robust global economy.

Therefore, the main conclusion that I draw on the subject of the economics of independence for Scotland, is that the evidence is probably consistent with making an argument in either direction, but that the central expectation should probably be for little impact either way. Independence or union are both economically feasible, and our choice between these options is political rather than economic.

(*) Personally I think this is overvalued but if other countries are willing, in aggregate, to pay vast sums for a product that could be produced anywhere but just not labelled 'Scotch' then that's up to them!

1 comment:

  1. A criticism & My response:

    "I wonder why agglomeration requires independence or, having a capital city. For example, new capitals such as Brasilia, Canberra, Ottawa and others haven't attracted 'agglomeration' of private firms, while if one follows your argument there should be lots of private firms that want to be geographically close to the government."


    "Indeed, I agree with you. I don't claim that having government functions in a particular location is a necessary or sufficient condition for this, only that there will be a tendency or correlation between capital city functions and head office functions. There will also be a large degree of path dependence in this mechanism (i.e. I don't expect large companies to relocate to Edinburgh on the advent of Scottish independence, however a growing medium sized business within Scotland currently may reach a scale at which it believes it is best served by moving head office functions to London; the future government of an independent Scotland will have an incentive for this not to occur and could create conditions such that it doesn't - I don't believe that the artificially created capitals that you cite had this same incentive to prevent domestic firms relocating to Rio, Sao Paulo, Syndey, Melbourne or Toronto.)

    The UK is particularly centralised in this regard and other countries do better. Given the current centralised nature of the UK, I believe moves to decentralisation (including but not limited to Scottish independence) could be beneficial."