Monday, 22 September 2014

Post Referendum Policy for the SNP

Scotland will never be independent until currency is not an issue that concerns people over the transition. People were too scared, and will be too scared. The Scottish Government's proposal of a currency union was clearly sub-optimal economically and was rightly attacked by many economists. But alternative proposals of joining the Euro or creating a separate Scottish currency were never going to fly given voter psychology.

I think there are two routes for currency becoming a non-issue at a future putative referendum: the first is for the UK to join the Euro. This I don't see happening any time soon.

The second route is via the creation of a confederal UK. Gordon Brown, in his seizing of the political initiative two weeks ago, has created a clear mandate from Scotland for the UK as a transfer union in which risks and resources are "pooled and shared". But given 45% of a very high turnout voting for independence with many of the remaining 55% favouring further powers under the competence of the Scottish Government, I don't think Jack Straw has any mandate for his proposal that a No vote is made permanent and that the UK becomes like Spain in its claims of constitutional integrity. Rather, the 1.6 million votes for independence, plus many more for enhanced powers, is a strong vote for confederation.

Confederation is the opposite of devolution. Currently Westminster devolves power to Holyrood. Under confederation, the Scottish Parliament would cede powers to the UK parliament. The referendum has made clear that those powers should be defence, foreign affairs, monetary policy and, thanks to Gordon Brown's intervention, fiscal policy. Confederation initially would cede exactly those powers that are currently "reserved" under devolution. This is what I feel the SNP should switch to campaigning on (perhaps they could draft the addendum that the UK Government would have to add to a forthcoming Scotland Bill on further powers) rather than any crazy suggestions like changing the mechanism of achieving a mandate from referenda to simply winning elections.

The advantage of confederation for the independence movement is that it would be clear that sovereignty ultimately rested in Scotland, and because of the current democratic will, powers were currently passed upwards to share within a supranational union. If the democratic will changed, the detail of which powers were ceded could change (even all of them, contra Jack Straw). In particular, if the democratic will at some point in the future no longer favoured a fiscal union, or representation by the UK internationally (i.e. in EU or in NATO) but still favoured a monetary union (*) then Scotland could cease to cede these powers to the UK level. This is effectively the independence of the Scotland's Future White Paper - but it wouldn't feel like it to a risk averse electorate, or to an electorate that valued a British national identity, since British institutions would always remain. It would also avoid any traumatic transition periods, eliminating the risks of capital flight and market collapse, and lowering start-up costs since the creation of institutions could be gradual.

(*) This would incorporate fiscal sharing arrangements as outlined by BoE governor Mark Carney, and crucially the laws and the detail of this fiscal sharing arrangement would be decided by UK institutions. This would be a monetary union that prescribes (G-T)/Y and specifies, ex-ante, transfers in response to asymmetric shocks; it would not prescribe G/Y and T/Y separately, or the detail of tax and welfare policy, which are prescribed in any immediate post-referendum arrangement.

Wednesday, 17 September 2014

The Economic Choice on Thursday

Over the last couple of days I've tried to lay out a series of mechanisms whereby independence - perfectly conceivably - leads to better outcomes. Mechanisms for economic gains from independence #1, #2. #3, #4 & #5.

This is partly in response to articles like this in the Daily Record in which some economists claim that the evidence all points one way. It clearly does not. This is not to say that Yes has all the evidence on its side: in particular, a currency union is bad idea; and I would hope that an independent Scotland adopts a Scottish currency. Such a currency should be pegged to Sterling initially to allow existing Sterling denominated liabilities (mortgages etc) to be paid without currency risk. New liabilities that are taken on should be denominated in the Scots currency, and when exposure to Sterling is minimal, the peg can be broken if appropriate.

I think the economic choice on Thursday can be summarised in the following way:

The Scottish economy is performing as well as the UK economy at the moment, and the Barnett Formula roughly compensates Scotland for North Sea oil tax revenues. But on the horizon are two major challenges: an ageing population, and the decline of the North Sea. The campaign pitches are both, fundamentally, about how these challenges are faced.

# The No position is to not do anything about these issues at all. What it proposes instead is that Scots can be reassured that they will start to receive transfers from the rest of the UK that allow public services, pensions, etc to continue to be paid even as economic output in Scotland falls.

# The Yes position is that we don't want these transfers and that we need to do something to make sure that economic output does not fall. This something is not exactly defined: "a government with the best interests of Scotland" is a sentiment consistent with this aspiration, but what exactly will differ policywise is not completely clear. A policy of increased immigration is clear and consistent, but other than this, little has been spelled out (which is of no surprise given that it is a matter for 2016 election).

Both these pitches have logic behind them. One is not necessarily more reprehensible or laudable than the other. An individual should vote on how appealing these pitches are (what are your preferences over them), and whether they trust them to be deliverable (how credible do you believe them to be).

Mechanisms for economic gains from independence #5

# Timing

Some people seem to think that the aftermath of a financial crisis, when public debt levels, and the risk of hitting the zero lower bound for interest rates, are high, is a bad time for declaring independence. I'm not denying their mechanisms, but they are ignoring the headline lessons of Keynesian economics: times when labour is un/under-employed, and when capital is cheap (risk free interest rates are low), are the best times to incur the transition costs of independence.

In times of full employment, with "normal" interest rates, the need to spend resources setting up the institutions of a new state would crowd-out resources from the private sector. However, in these depressed times, this additional spending could pay for itself by drawing upon otherwise unemployed resources.

Notwithstanding today's good news on jobs (which certainly doesn't go as far as getting us back into the realms of full-employment or away from the zero lower bound on interest rates) the additional demand from the need to cover the transition costs of independence could be just the kick-start the Scottish, and rUK, economies need.

Mechanisms for economic gains from independence #4

#4 Mean Reversion

This mechanism's perhaps a bit unfair since, if it's true, then it applies to both independence and union. If it's not true though, then conclusion must be that we expect gains from independence. In either case, the economic outlook is brighter than often painted.

In A conversation on the economics of independence, I suggested that there must be an institutional reason for the regions of the UK excluding London and its environs occupying all of the poorest places in the ranking of northern European regions which had never been communist. This contention was made because I could think of no structural or fundamental reason for these UK regions to be so disadvantaged. If this contention is correct then we should expect institutional change, such as independence, to be accompanied by economic gains.

However, there is another possibility: luck. Perhaps the regions of the UK excluding London and its environs have experienced an unfortunate series of bad outcomes. If this is the case, then we should not expect this run of bad luck to continue, and these UK regions should "revert to the mean".

Certainly Scotland's experience over the past century has been particularly poor in a European context. This can be most clearly seen from population statistics. As I discuss in Population Records, "whether economic success determines relative demographics or vice versa, these statistics clearly co-vary and looking at the outcome of relative migration can tell us about the outcome of relative economic performance. Over the 20th century, Scotland did terribly on net migration and population growth."

If this was bad luck, then we should expect to do better over 21st century because of simple mean reversion. If this was due to institutional features, then we should expect to do better by changing institutions.

Mechanisms for economic gains from independence #3

#3 Spillovers from statehood and location of central government

My own favourite mechanism for possible economic benefits from independence (relative to being a peripheral region of a larger country) is the positive externalities that may accompany the very fact of statehood.

As soon as a region is a country, international companies treat it differently. Many need to base at least a small office, with at least some local autonomy, to ensure legal compliance and appropriate marketing. The direct economic effects of this are that these international companies incur extra costs, and the new small country experiences extra private demand and public revenues from this local employment. These direct effects are likely negative in the aggregate (the company has incurred extra costs), but are likely positive within the new small country.

As soon as a region is a country, it both sends out and receives diplomatic staff. On the assumption that it sends out as many as it receives, the direct economic effects of this are zero: the government is paying salaries to the diplomatic staff that it sends out into the world, and roughly this amount extra of private demand is added to the local economy from the diplomatic staff that it receives from the rest of the world.

As soon as a region is a country, the status and responsibility of government officials and civil servants is enhanced. The Institute for Government's Robyn Munro reports in the LSE's British Politics and Policy blog that "In the event of independence the Scottish civil service would ... require ... a rebalancing of the grades and experience levels of its employees. ... UK department staff based in Scotland are drawn disproportionately from the lower grades (AA, AO and EO), with few senior civil servants." Under the assumption that fixed costs in public good provision are neglible (*), and the further assumption that the current bill paid by Scottish taxpayers funds current civil servant employment in Scotland, then on independence with the same level of public good provision, Scotland would need fewer civil servants overall, but more at senior grades. The direct economic effect of this is zero: the same government expenditures and the same private spending power.

These three changes provide no great direct overall economic boost or cost to the new small independent country. However, they are associated with indirect economic effects which should be beneficial:

# Firstly, the local offices of international companies are a source of informational feedback: local demand is more fully understood, and the company is more likely to have the capacity to respond to this information.

# Secondly, as a junior civil servant, interaction with senior colleagues within the same building rather than them being 600 miles away in London is likely to boost human capital accumulation.

# Thirdly, growing companies need to discuss their business with government - particularly with senior people who have the authority to effect any changes needed. Being able to have these discussions in Scotland means that these companies, as they grow, are more likely to stay in Scotland. If they have to go to London every time they need to have a meeting, they might as well base themselves in London. Further, growing companies need the full range of business support services. Government procurement by an independent state on advertising, legal services, research and analysis etc mean that these services are much more likely to be available locally. Gordon Young, the publisher of The Drum, describes this business ecology effect well in relation to the marketing industry.

# Fourthly, these three changes, as well as the increased propensity for growing companies to stay in Scotland, provides visible job opportunities at senior and high status grades. This is likely to mean that school levers and graduates in Scotland are less likely to automatically assume that London is the place to go for a high status career, and it is likely to provide the pull for increased high ability immigration. Many high status roles, leads to many high ability candidates applying for roles, which increases the chances, for a firm to find an appropriate hire, which lowers the costs of doing business. This is the beneficial effect of "thick markets". In peripheral regions with no autonomy, we find truncated talent distributions (because the talent leaves) which makes them unproductive and therefore unattractive to talent. To break this cycle you need to provide opportunities for talent.

(*) Deaner & Phillips (2013) [Section 5.1 ‘Spending by service area – how might it change?’ on page 62 and 63] do not find any evidence of scale economies when looking across Europe at the costs of providing public services in countries of different sizes.

Tuesday, 16 September 2014

Mechanisms for economic gains from independence #2

#2 Smaller is less risky and more robust, with lower costs from complexity:

From Nassim Taleb

Small is beautiful and more robust.

Most journalists are trapped in verbalistic concepts devoid of logical/empirical clarity, & are to be taken in reverse. A New York Times article claims: "big countries tend to be more resilient to shocks.", which is pure BS. 

Just look around: Singapore, Denmark, Norway, Switzerland, Dubai, compared to their neighbors. Focus on otherwise same ethnicity (Cyprus vs Greece, Lebanon vs Syria). Things are a bit more complex: it is the decision-making unit which would put federations like Germany and the US in the same group).

Articles, by people affilitated with the Extreme Risk Institute, on SIZE (by yours truly): mathematical derivation of the statement that small is MORE resilient of SILENT RISK:

Note that for small state to do well, all we need is a "pax" of an Empire, "pax Romana", "pax Ottomana", etc. Which we have with EU, US, Nato, etc.

Mechanisms for economic gains from independence #1

#1 Animal spirits:

Quoting Andrew Wilson in conversation with Derek Bateman

Scotland changes with independence. We become more focused on getting the economy motoring so that we can create the society we want. I think as responsibility increases, the economic imperative grows.

All of the fundamentals are great for Scotland. We vote with more money, more resource, more information,and more of  a platform of existing government institutions [than the other 142 countries since WWII that have become independent]. There is no country taking this choice with more going for it. People need fear nothing. Are we up to it as individuals? Do we want to lie down and sleepwalk through life or are we willing to get out of bed and give it a go? And we know in life that if you let life happen to you then you don't succeed and you don't reach your full potential. If you just set a goal for yourself and go for it, all things are possible. It's called belief.

Thursday, 11 September 2014

A conversation, between economists, on the economics of independence

Surely there are solid arguments for negative effects from being a small country relative to being a large country? Economies of scale, the existence of border effects, liquidity premia, and so on?

Yes. Economic theory has proposed many plausible mechanisms that mean that large size should be associated with greater productivity and greater wealth. Further, when attempts are made to estimate the size of these effects, they turn out to be not insignificant. For example, see my own work which suggests that if the only change on Scottish independence were that it traded with the rest of the UK in the way that Ireland seems to trade with the UK, then this should be associated with a 5.5% fall in Scottish GDP.

However, these effects apply to all countries, not just Scotland, and if this were all that was going on then we should expect to see larger countries richer than smaller countries. As shown by Rose (2006), the economic literature on this generally finds no effect of size on growth or level of income (some papers even find a negative correlation e.g. Alouini & Hubert (2010)). This null result can be explained by supposing that there are non-GDP benefits of independence and richer and more productive regions, which can afford the trade-off, choose independence. This selection effect would mask the true relationship between size and GDP.

This selection effect however does not convince me. Given the persistence of national borders, then the randomising effect of technological change on productivity of different regions over time should mean that a small productive region which made the choice to be independent several hundred years ago is expected to be no more or less productive than another region that was poor several hundred years ago and made the choice to remain as part of a large country. Given random productivities, the benefits of size should be visible. They are not.

This either means that the benefits of size are wrong (I don't believe this) or that there are countervailing effects. Perhaps small countries are better run or function at a more appropriate scale (convex costs of complexity?). Perhaps there are spillover benefits to running a country rather than being a peripheral region of a larger country like the ability to attract talent (high status government employment, and many international firms want at least a small office presence in your region) which leads to a more diverse business ecology, which involves the provision of the full range of support services that new and growing businesses require.

In any case, if the correlation between size and income is approximately zero, then it suggests that the (GDP-related) costs and benefits of size roughly cancel out. This does not, itself, provide a case for independence or for union. It just suggests that if we value independence for other, non-GDP reasons, then there does not appear be any significant GDP cost/benefit to pay/gain in general. Of course, there may be issues specific to Scotland and the UK could lead to the expectation of GDP costs or benefits of independence.

If there is no relationship between country size and long run growth/wealth then surely this is bad for independence, given transition costs?

Usually, yes. But Scotland already has most of the infrastructure of a state. HMT's estimates of the transition costs were rubbished by the author whose research they relied upon. In any case, even if HMT's figures were appropriate, this is a one off cost which should be met by extra government borrowing and amortised over a very long period. If we, extremely pessimistically, assume £3bn cost at 5% borrowing rate, then this is an annual cost of £150m or 0.1% of GDP. This is not a big issue.

Lumping lots of disparate countries together produces this zero correlation between size and income. Would it not be more valid to consider subsets of reasonably similar polities? For example biggest is richest for Spanish-speaking Latin American countries (excluding Puerto Rico which is really part of the United States). And for English-speaking countries, the largest, the USA, stands out as the richest, in spite of the fact that it does not appear to have better institutions or national endowments per capita than Canada, Australia or New Zealand.

Interesting points. I'm glad you thought of making comparisons across countries which, other than size, have some similarities. I contend that a suitable comparison group for looking Scotland and the UK is the EU members of northern Europe which have never been communist. For these 11 countries (Ireland, UK, France, Belgium, Luxembourg, Netherlands, Germany, Austria, Denmark, Sweden, & Finland), there is a significantly negative correlation between size and income. Set against the Spanish speaking Latin American countries, or the worldwide English speaking countries, this isn't something that nails the argument - but it does show that your other two examples certainly don't nail the argument either.

More interestingly, looking at these countries allows us to make a specific point about Scotland and the UK rather than considering only the general size of countries issue. Eurostat has data that divides these countries up into 48 "NUTS1 regions" (*). These are shown in the graph below. I know of no reason to expect that 7 of the 12 UK regions should occupy the bottom 7 places in the ranking, with 11 of the 12 in the bottom half. The UK is not less fertile, it is not landlocked, nor is it lacking in natural resources (indeed it has the largest oil and gas reserves of any of these 11 countries). I contend that this is indicative of institutional problems in how the UK is run: perhaps to the benefit of London which is one of the richest regions in Europe, despite the poverty of the rest of the UK (indeed, the UK has the highest regional inequality in Europe). Are we to believe that it's luck that all the poorest regions are in the UK? Ireland had income per head of 70% of UK average when it gained independence in 1922, now it is in the top half of this ranking and would be the UK's second richest region if still in the UK. Escaping whatever causes the outcomes shown in this graph provides a clear expectation that Scotland can gain - in GDP terms - from independence. This is of course in addition to the non GDP benefits like electing political parties more closely aligned with preferences of the Scottish electorate.

(*) All NUTS1 regions of these 11 countries excluding 1 region from France: French overseas territories - not in northern Europe; and 6 regions from Germany: the East German Länder - formerly communist.