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

End June Links

# I've been interested in "critical transitions" before, and recently read Nassim Taleb's book Antifragility (essentially about concave impact from risk realisations, combined with fat tailed risks), but this Less Wrong post suggests a link: Anticipating Critical Transitions.

# Miles Kimball links to posts on negative nominal interest rates including this from Willem Buiter: The wonderful world of negative nominal interest rates, again

# The basic thesis of Iain MacWhirter's 'Low pay is a cause of stagnation, not a consequence of it' is pretty standard. But the conclusion gets to the crux of the economic case for independence. Rather than the analysing the pounds and pence of the current fiscal situation, the debate should be focussed on whether the following is correct, and if so, the constitutional settlement that will best address it:
"Scotland has to reconnect with its manufacturing past. Scotland was one of the most advanced industrial civilisations in the world a century ago, a cradle of the industrial revolution. There was nothing inevitable about Scotland's industrial collapse – it was the result of economic policies that allowed Britain to become grossly over centralised in the South East of England.
And it's still happening, with the London Mayor, Boris Johnson, launching his “Vision for 2020” this week, demanding even more national wealth being poured into the infrastructure of the metropolis, in order to make one of the most congested regions on the planet even more congested.Whatever happens in the Scottish independence referendum, the priority has to be preventing this relentless southern vortex of wealth and power from sucking the economic life out of Scotland and turning this country into a tartan theme park. Scots may be unconvinced about the merits of formal independence, but there is a greater understanding today about the causes of Scotland's decline than ever before, and a greater determination to reverse it. That should be the top line on the manifesto of every party in Scotland in 2014."
Gerry Hassan's 'Living on an Island: Scotland and the London Question' is another good piece on a similar theme.

# I really need to look at and understand Steve Keen and this post looks like a good place to start: Gasping in Krugman's ocean of theory

# Another excellent post from Interfluidity that rationalises the accumulation of scale and interconnectedness in regulated finance, and the accumulation of information in regulated surveillance, as consequence of organisational evolution - and in particular the role that regulation plays in this evolution.

A speculative idea about currency unions

Angela Merkel wants unemployed Europeans to move, this after Paul Krugman pointed out the dangers that this has within a currency union in the absence of fiscal integration. A country gets into trouble: recession and high unemployment leads to budget deficits and a run up in the government debt levels. If the population then leaves to work elsewhere there will be no-one to restore the fiscal balance and, ultimately, repay this debt. Can currency unions actually work then?

How about this for an idea: the central bank guarantees a level of nominal GDP growth at the level of the whole union. States within the union issue bonds denominated in the currency of the union, but indexed to their own relative level of nominal GDP - the level of which is not guaranteed. This means that if bonds are issued to cover recession induced deficits but the young then emigrate, the level of the debt will be written down in respect of the relative fall in nominal GDP.

The only issue I can see is ensuring the objectivity of the entity which reports the relative level of the nominal GDPs of the countries within the union.

Related: the more I think about it, the less convinced I am about a Sterling Zone for a post independence Scotland. I'm becoming more pro Eurozone again - it's a much more symmetric grouping of countries, and to first order it is, like the USA, a closed economy. But there are all sorts of reforms needed: hence the ideas!

Passed...

... my PhD!

Some celebratory tunes:

Secova - Kindle

Also I am profiled in The Actuary magazine. Bet Paul Krugman cannae say that!

Independence as a “Real Option”: Explaining the campaign so far

A common refrain from pro-union campaigners has been for the SNP to provide detail around “what independence would look like”. To the extent that a vision of an independent Scotland has been provided by the SNP (not necessarily by Yes Scotland), differences with the status quo have been minimised.

The vision that the SNP have articulated has suggested a great deal of continuity: the Common Travel Area between the UK and the Republic of Ireland provides a model of continuing open borders; maintenance of the monarchy; continued membership of the EU and NATO; an emphasised “Social Union”; evidence that maintenance of the level of tax-and-spend is affordable; and, especially, the favoured option of a Sterling Union. This vision has led to the response from some on the pro-independence side that this does not optimally use the levers of independence, but it has also seemingly provoked the pro-union side (who might be expected to view this vision of continuity as second-best after their preferred union option) who also argue against this vision partially on the grounds that it would fail to deliver “genuine freedom”! Can we economically rationalise these positions?

Assume that, unless explicitly changed, “things” (by which I mean essentially everything) will continue to be the “same” after independence. What then is the value of independence? Independence could be viewed under the lens of real option theory: a real option is “the right — but not the obligation — to undertake certain … initiatives”. Under union, the Scottish Parliament cannot award itself new powers and “things” will of course continue to be the “same”. Under independence, “things” are the “same” until such time as, presumably, we don’t like this “same” path for “things” and the Parliament exercises this option and decide to change these “things”. Options are always valuable (since they represent a right but not an obligation). This means that if the SNP can make the case that “things” will continue to be the “same” after independence, and that independence represents an “option” to change things then, by this logic, independence is objectively optimal.

This is a potential explanation for the Independence-lite vision of the SNP which essentially points to how similar “things” will be after independence. It presents a scenario under which independence is almost objectively optimal. This is also a potential explanation for the vociferous objections to this vision from those opposed to independence. To counter the SNP vision, the pro-union campaign has to convince voters that “things” will not be the “same” after independence and they essentially have three channels in which to do this:

1. the first is to assert that “things” will not be the “same” even under the SNP’s vision because of, for example, transition costs or risk exposures;
2. the second is to claim that the SNP’s vision is impossible to implement, and so we cannot keep “things” the “same” (as in the HM Treasury paper on a Sterling Union);
3. and the third channel is to argue that “things” won’t be the “same” because the option will be exercised immediately: an independent Scotland will choose “genuine freedom” instead of keeping “things” the “same”.

This sums up many of the campaign dynamics so far: the logical optimality of independence under the assumption of keeping “things” the “same” perhaps explains the SNP’s Independence-lite vision; And the third channel available to the pro-union campaigners perhaps explains the enthusiasm with which they point out that constrained independence does not represent real independence.

Originally posted on esrcscotecon

End May Links

Nick Rowe's Monetary stimulus vs financial stability is a false trade-off is a great description of general equilibrium outcomes as against the micro-mechanisms that they arise from: lower interest rates may induce me to save less from my (exogenous) income; but at the macro level, lower interest rates do not imply that there will be a lower savings rate applied to the (endogenous) national income.

Simon Wren-Lewis and George Kerevan discussing, in completely different ways, the rise of UKIP. My favourite UKIP post though was this spoof from the Daily Mash.

Paul Krugman makes the point that needs made again and again: to the extent that something which we might call "austerity" is needed, this austerity should be about working harder and not seeing the rewards in terms of higher consumption i.e. more work, less play; it should not be about mass unemployment.

Fascinating: French fertility fall

Concentrating economic activity in London

I've posted my first blog post at ESRC The Economics of Constitutional Change blog. It's entitled The decision to concentrate economic activity in London. Comments should be left here though as we're not accepting comments on the ESRC site.