End September Links

# Interesting academic research:
   - Recasting international income differences: The next-generation Penn World Table, Robert C Feenstra, Robert Inklaar, Marcel Timmer
   - Immigration, diversity, and economic prosperity, Alberto Alesina, Johann Harnoss, Hillel Rapoport
   - Creativity, cities and innovation, Neil Lee, Andrés Rodríguez-Pose
   - The economic future of British cities, Henry Overman

# Savings, investments, and a dose of realism - Frances Coppola is nicer than me about greetin' faced savers organisations...

# Typically interesting posts from Chris Dillow, On wage-led growth; & Interfluidity, Not a monetary phenomenon & Terminal demographics

# Chris Dillow gives a pointer towards some literature on diseconomies of scale: The Management Question

# How relevant is this for any proposed Sterling Union? Why asymmetrical monetary unions are bound to fail

# A useful resource: Migration in Scotland

# Interesting column in the Guardian: UK Growth? Make London independent to mend the North-South divide. I'm not sure about conclusion though: "Were the government to publish regional trade figures, they would show that London runs a current account surplus with the rest of the UK, offset by capital transfers from the rich south to the poorer north. As an independent city state, London would have a higher exchange rate and higher borrowing costs. The rest of the country would, by contrast, get a competitive boost." A London GOVERNMENT would be in surplus vis-a-vis the rest of the UK, but that's not the same as London running a current account surplus (selling to more than it buys from) and paying capital transfers north. I suspect that the private savings made by the rest of the UK, on net, go TO London. And it definitely does not seem obvious to me that total capital flows (private savings plus fiscal transfers) are from London to the rest of the UK. Of course I might be wrong...

# From same column, I'm also interested in the point about "the strength of persistence over time in patterns of relative unemployment at local level" (which comes from a Paul Ormerod article in Applied Economics Letters): are markets not flexible enough, or is policy not good enough? If it's the second point then the North-South divide would argue for the existence of policy that was good for the South but not so good for the North. And the relevance of this to the Scottish independence debate is...

A fair division of reputational assets

In the Scottish independence debate, HM Treasury has asserted, in the first of its Scotland Analysis series of papers, that Scotland would become an entirely new state, with rUK inheriting the legal personality of the current UK. Needless to say, the Scottish Government did not agree with this statement and Nicola Sturgeon pointed out its status: it is legal opinion, this is perhaps very well informed opinion, but opinion nonetheless. This was much discussed at the time in terms of its implications on EU membership etc, but a new implication of this assumption is emerging.

At the International Conference on Economics of Constitutional Change held last week in Edinburgh, Dr Angus Armstrong of the National Institute of Economic and Social Research (NIESR) presented a paper on the currency options for an independent Scotland (Armstrong & Ebell), making the link that debt levels were an important consideration in making this currency choice. The analysis underlying this paper appears sound: it concludes that a small state with volatile tax revenues will pay a higher interest rate on its borrowings than a larger state with stable tax revenues (for a given average tax revenue per unit GDP, and debt stock level per unit GDP). The methodology looks solid and the conclusions are intuitive.

I do however question the assumption made in this paper about the splitting of debt. It suggests that rUK is "the continuing UK" and that newly independent "Scotland would also have to compensate the continuing UK for being relieved of its fair share of the existing UK public debt at the time of independence". Whilst both the UK and Scottish Governments have agreed that the assets and liabilities of the current UK should be split fairly, they may disagree on the method of this splitting, and what constitutes 'fair'. However there seems to be an emerging consensus that assets fixed in geography should accrue to the country in which they reside, and moveable or financial assets and liabilities should be split on a population basis. So let's consider splitting the UK debt by population and look at the consequences of assuming that "Scotland would also have to compensate the continuing UK for being relieved of its fair share of the existing UK public debt at the time of independence".

To simplify things massively let's assume that:
# the market value of UK debt, at the point at which it is to be split, is £1359B
# this is all 5 year zero coupon bonds
# which yield 2%p.a.
# Scotland is 10% of the UK by population
# The analysis in Armstrong & Ebell suggests that Scotland would pay 3.5% on its debt [this is not the real number from the paper, but just to keep things relatively simple].

The face value of the outstanding debt stock is £1500B. I think a reasonable way to split this is that Scotland becomes responsible for repaying 10% of this face value, £150B, as it becomes due. rUK would pay the other £1350B on the due date. The current market value of the debt will fall as existing creditors are not as happy with their new counter-parties as they were under the previous union. But this happens after every election: a prudent government issues debt for sensible reasons at low interest rates; then loses an election to an imprudent government and the interest rate rises; existing debt-holders get burnt. The Scottish independence referendum is another election, and not one that creditors can reasonably claim to have been ignorant about: most of the existing debt stock has been issued since 2007 when the SNP first came to power.

However, if the rUK was to be considered as "the continuing UK" then the scenario I've outlined in the previous paragraph may constitute a default by the UK - something that "the continuing UK" will never do. And if instead Scotland has to buy out the debt from rUK by raising new Scottish debt, it would need to pay rUK £136B to extinguish its liability, by issuing 5 year zero coupon bonds with face value of £161B - rather than £150B. This boils down to saying that in order for rUK to maintain the reputation of the current UK in international credit markets, Scotland should pay a premium. Is this 'fair'? In my view, any reputational assets currently "owned" by the UK should also be divided fairly.

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.

End August Links

# Simon Wren-Lewis and Paul Krugman describe the objectivity of analysis produced by the civil service in assessing Gordon Brown's 5 tests for joining the Euro. I think it's fair to say that the positions taken by civil servants in producing the Scotland Analysis series for the UK Government and the various Scottish Government papers have been much less impartial.

# Noah Smith thinking in thought experiments: Does private sector net saving necessitate government net borrowing? A trivial example, but this is the way thinking should be done.

# Why savers can't have nice things: it's all about time travel; Why @saveoursavers are doomed, & Depressions are bad for debtors and creditors, and workers and bosses

# Another North/South divide in the UK

# John Kay's speech at Glasgow University transcript: "Here we come up against one of the most serious problems of Scottish business, the drain of Scottish business and Scottish headquarters out of Scotland over 20, 30, 40 years. How much of that is due to Scotland’s membership of the United Kingdom and how much would have happened anyway in a world in which London is a major financial and business centre is an open question. But certainly, Scotland has not been able to adopt policies of retaining corporate headquarters within its boundaries in ways that it might have been able to do as an independent country." An important question about how constitutional set-up can influence economic outcomes.

# Great comment from Simon Wren-Lewis on Tory macroeconomic policy: The wrong sort of recovery

# This needs to be expanded upon: I have sympathy with the view that this might be true, but I need a theory for why it's true; simply stating it is not enough. "Scotland is a surprisingly elitist society where a relatively small number of people own land, run businesses, own wealth, stand for election and run government. The result is a deep-seated belief that ordinary Scots cannot own and run things, don’t want to own and run things and indeed that it hardly matters who does. It matters. It matters so much that talented folk still leave Scotland instead of pushing for fundamental change. Well-intentioned public servants scour the universe for an explanation of the Scottish Effect (where Scots health is consistently worse than English counterparts in areas with similar levels of deprivation). Perhaps the answer is simple. Perhaps the sheer stultifying burden of disempowerment has finally caught up with us all." This is important not just for Scottish Independence and the referendum, it also has strong message for the economics of inequality: inequality is usually deemed to be bad because the poor have a higher marginal utility of consumption (this reason has also been augmented with newer theories with utility over status or rank). But the quote also hints at negative impacts upon human capital development i.e. supply side impacts of inequality; and how inequality impacts upon self-identity which has knock-on impacts on supply ("we cannae dae it", where "we" means Scots).

# Krugman's 'Banks and the monetary base' made sense to me; but then so did Interfluidity's 'Banks and macroeconomic models'; and even Steve Keen's 'The reductionism stops here'. And they can't all be right...

# Self publicity!

# For future reference: Final version of Tyler Cowan's International Trade class reading list

Population Records

Last week the General Register Office for Scotland released figures that showed Scotland’s population had reached a record high (although the growth rate, far from breaking any records, has slowed). The population overall continues to age, but births have increased and Scotland has attracted net migration both from the rest of the UK and from the rest of the world.

Human capital is likely an important determinant of long-term economic success, since labour is obviously an input into production. Conversely, relative productivity is likely an important determinant of the direction of net migration and other demographic statistics: we could imagine that a small open economy offers a wage conditional on productivity of other factors, and attracts a corresponding labour force to equalise marginal product of labour; and therefore net migration flow indicates higher productivity of these other factors. 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[1] (though somebody has to be at the bottom!). The closest “challenger” to Scotland was Ireland who can be said to share an “emigration technology” with Scotland as regards emigration to USA/Canada/Australia/New Zealand: the English language. Scotland’s population growth was worse than Ireland’s, and much worse than rUK’s – who also shared this English language “technology”, and who should have shared the same government policy framework. Within UK now, approximately 800,000 Scots live in rUK against on approximately 400,000 from rUK living in Scotland.

However, since 1999 Scotland has done better: in particular net flows across the Scotland-England border are now approximately balanced[2], and Scotland reversed its population decline with in-migration from Eastern Europe over 2000-10. Last week’s statistics demonstrate that in-migration remains favourable.

Is Scotland’s improved demographic performance related to achieving limited self-government with the advent of devolution in 1999? Is this a spurious association? Does it indicate that there was poor economic governance up until devolution, but that we are now in an optimum arrangement? Or perhaps it indicates that control over institutions is beneficial, and more control (e.g. independence) would be even more beneficial?

The Office for National Statistics map of UK population increase[3] can be read in support of the interpretation that proximity to power is related to population growth (and presumably also to net migration, and to relative economic performance). The fall-off in the rate of population increase as distance from London increases is evident (high fertility in Northern Ireland excepted), and perhaps Holyrood is the only reason for Scotland’s rate being above that of the North West and North East of England? Interestingly it is also the case that, within Scotland, Edinburgh and the east saw population increases, while population fell in the west.

First posted at http://esrcscotecon.com/2013/08/11/population-records/#more-433

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[1] Country data from GapMinder, Scottish data from Wikipedia (rUK = UK – Scotland).

[2] Chart 4.09 Fiscal Commission WG http://www.scotland.gov.uk/Resource/0041/00414291.pdf

[3] As tweeted by the BBC’s Mark Easton

Inflated emphasis in the news

From the BBC: "The Bank of England has outlined its strategy for future interest rate changes - and it is likely to mean further pain for savers, but continued cheap mortgage rates."

But in the self selected set of economics blogs that I read, yesterday's Inflation Report represented a tightening of monetary policy. The BoE is "targeting high unemployment", and using a poorly designed system (the specified "knockouts" would have suggested that the BoE tighten policy in the middle of 2008 - this makes them almost self-evidently wrong-headed indicators). And given that the market fell and the pound rose on the news, it's likely that these views represent something like the consensus view in financial markets.

So given that creditors tend to benefit from tighter monetary policy and borrowers from looser monetary policy, and yesterday represented a tightening of monetary policy, why has much of the media focused on complaints from greeting-faced savers groups?

Large Markets, Gains from Trade, and a Puzzle

The latest paper in the UK Government’s Scotland Analysis series was released last week by the Department for Business, Innovation and Skills. The BIS paper describes the benefits of a large market for business, workers and consumers. This detail is fine: economists typically do believe that trade is usually mutually beneficial and so barriers to trade, such as a national border, are damaging at the margin. Indeed, I have written a paper on the economics of independence for Catalonia from Spain (see Comerford, Myers & Rodriguez Mora (2013)) in which this is the very mechanism at work. Sub-national entities appear to trade much more with the other parts of the nation state of which they are a part than independent nations do with their neighbours. Sharing a state seems to be a trade enabling technology, and this trade is valuable, with positive effects on welfare. Preliminary estimates (using the methodology of Comerford, Myers & Rodriguez Mora (2013)) of the welfare cost to Scotland of creating a national border between Scotland and rUK are of the order of 5% of Scotland’s GDP.

Successful small independent nations engage in more international trade than their larger counterparts. So perhaps small nations develop institutions that are conducive to international trade, and their international borders cause smaller frictions than the international borders of larger nations (for whom international trade is less important)? However, model calibrations do not suggest that the extra trade that we see in the data is due to a greater ability to engage in such trade: the international borders of small nations seem to cause frictions that are equivalent to the frictions caused by the international borders of larger nations. Instead small nations seem to be compelled to engage in more international trade due to the small size of their domestic markets. Therefore we cannot expect the reallocation in Scotland’s trade from rUK to the rest of the world to produce welfare effects that mitigate the 5% estimated cost – these reallocations are already assumed in that calculation.

This is starting to sound conclusive: trade is good and eliminating international borders is a mechanism that generates more trade. However, if this were the case, then we might expect to see a systematic positive relationship between country size and wealth. We see no such relationship in cross country data (see Rose (2006)). A quick back of the envelope calculation of the elasticity of per capita GDP with respect to national population using 2005 data from the World Bank shows that any relationship that there is between population and wealth would seem to be negative[1].

Country Grouping	Elasticity of GDP per Capita w.r.t. Population Size
Whole World	-0.154***
OECD	-0.058
EU15	-0.139*

Perhaps the importance of trade is overstated? This is possible but the calibrations used in Comerford, Myers & Rodriguez Mora (2013) are consistent with the latest estimates and advanced methodologies in the literature (see Arkolakis, Costinot & Rodriguez-Clare (2012) and Simonovska & Waugh (2013)). If the positive effects of trade are real, then conditional on the real wealth distribution of countries, this implies that smaller countries must compensate: they appear to have higher intrinsic productivity (i.e. a higher productivity before considering the impact of trade). Comparable results to the above table but now for the elasticity of this intrinsic productivity with respect to national population are:

Country Grouping	Elasticity of intrinsic productivity w.r.t. Population Size
Whole World	-0.334***
OECD	-0.221***
EU15	-0.293***

If we could interpret these figures as representing a causal relationship, then they suggest that Scotland would more than double its intrinsic productivity on achieving independence[2], an effect which dwarfs the 5% estimated cost of a border with rUK. However, we cannot interpret these numbers as causal and we can imagine clear endogenous mechanisms that may generate such observed relationships: perhaps productive regions, being already wealthy, choose independence whereas less productive regions, who see their wealthier neighbours, choose to join a larger state; this would give the appearance of small states being associated with high productivity. On the other hand, we may also imagine mechanisms that would enhance productivity in small independent states when compared with the peripheral regions of larger states: perhaps there are spillovers from having head office functions rather than branch offices, and head offices preferentially locate to be close to decision makers at nation state level rather than local authority level; perhaps simply economic governance works better in smaller states.

Whatever explains the discrepancy between the predictions of models with Gains From Trade, and the observed relationship between country size and wealth, I do not mean to suggest that net benefits for Scotland from independence are to be expected. I simply point out that the BIS paper’s focus on the costs from the loss of the UK single market is a partial analysis, and one which, in particular, cannot account for the success of small open economies.

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[1] The results in the table should be interpreted as e.g. countries in the EU15 with twice the population of their peers have, on average GDP per capita that is 14% lower than in these smaller peers. *, ** & *** respectively represent significance at 10%, 5% & 1% levels in these naïve regressions. For these results to represent a true statistical relationship, it would need to be the case that log Population was causal for log GDP per capita, but that log GDP per capita was not causal for log Population. This is clearly not satisfied, so what we are looking at is simple correlations in observables rather than any structural relationship.

[2] Change in intrinsic productivity ~ exp(-0.3*ln(5million/60million)) > 2