Monday, 9 September 2013

Sans Frontières

Number 5 in the 'Scotland Analysis' series from the UK Government was published last week: "it discusses the macroeconomic performance of Scotland as part of the UK ... and the potential impact of a border between Scotland and the rest of the UK". Despite much ridicule from Yes supporting quarters, I think the HM Treasury estimate of the size of the potential "border effect" between Scotland and the rest of the UK is on the conservative side. The argument that, because economic forecasts are generally rubbish, it is impossible to make the case that a particular intervention is likely to be economically costly or beneficial, is a fatuous one.

I have written about the border effect before: it is the real phenomenon under which trade within a nation state is much higher than trade across a national boundary, even a national boundary within the EU. Why? Who knows, but we observe that this is the case. If trade is valuable then the reduction in trade associated with the creation of a border will be costly.

Though it is a real effect, its importance should not be overstated: HMT report a long run (actually steady state) value of 4% of Scotland's GDP, and a not unreasonable parameterisation could produce anything up to maybe 10% of Scotland's GDP. HMT further suppose that this long run steady state might be reached in 30 years. If this is a reasonable timeframe, then we are discussing a mechanism which may have an impact on GDP growth of between 0.1% and 0.3% per year. Given expected GDP growth of between 2% and 3%, an effect of this magnitude will be almost undetectable on a yearly basis, but cumulative over time.

So the border effect will likely have only a small effect on annual GDP growth rates, but on whose GDP growth rates will it impact? The mechanism by which borders have an economic cost is that it prevents productive firms expanding and shelters unproductive firms from competition. If firms were geographically fixed then the cost of the border would fall predominantly on Scotland as the smaller party. However, the following scenario outlines a case consistent with a costly border effect, but under which the cost falls on rUK:

  1. suppose under union there are low barriers to trade and large markets; a productive new Scottish firm takes advantage of this situation to expand; as part of this expansion it makes use of London’s comparative advantage in supplying head office services and moves it’s management and R&D divisions to London, keeping its call centre in Scotland
  2. under independence barriers to trade are higher; the productive new Scottish firm cannot expand as much; so the overall output of the Scottish & rUK economies is lower; but this is London’s loss as the (smaller) firm stays in Scotland with its high quality management and R&D divisions providing high status employment;
Scotland could easily be better off under (2) even if London were marginally (unnoticeably) worse off [such that the sum of Scotland and rUK were even more marginally worse off] i.e. (1) is the efficient case, but Scotland prefers (2).

As the Treasury say, the border effect also applies to migration flows as well as trade flows. I have also written about migration and population: migration over the Scottish-English border is currently roughly balanced, but that this is an atypical situation by comparison with the 20th century. Even with balanced migration it is possible that Scotland loses out and could benefit from a reduction in these gross flows: this would be the case if these flows represented a net export of human capital from Scotland. Perhaps we export the brightest and best of our young people to the head offices of London, and import middle managers to run branch offices and pensioners to enjoy the views? Demographics also demand that Scotland cannot do with only balanced flows anyway: it needs “net imports” of young people. This may be increasingly unlikely within the UK if the political centre is dragged UKIP’s way.

To summarise, the critique of the border effect is fatuous and confuses a discussion of mechanisms with economic forecasts. The border effect is real and, all other things equal, it is a cost of independence which should not be rubbished. However, all other things are never equal, and if low barriers to trade mean that Scotland is exporting its productive capacity south, then the possibility exists that the border effect could be part of the reasons for independence.

And remember, HMT are currently working for political masters who want an In/Out referendum of the EU. The border effect applies there too.

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