With the Scottish referendum still in the balance, this blog comments on the key macro economic issues in the campaign, hopefully with as little bias as possible [1].

The currency question, fiscal policy and the risk of a deposit flight from the banks have been much debated, but in the end they are all linked to the age old question of taxation, with and without representation. Is Scotland really willing to risk paying higher taxes as the price of political independence? We will know the answer on Friday morning.

First, an irrefutable fact: whatever the outcome, Scotland will remain heavily dependent on the rest of the UK (r-UK) as a trading partner, but the same will not be so true the other way around. In 2011, Scottish exports to r-UK accounted for 29 per cent of Scottish GDP. But exports from r-UK to Scotland accounted for only 3.5 per cent of the former’s GDP. The economic relationship after independence would be a very unequal one.

This has major implications for the currency question. Scotland has to be very concerned about the competitiveness and stability of its exchange rate with r-UK, but it cannot expect this concern to be fully reciprocated. If r-UK sees fundamental economic objections to a currency union with Scotland, as the Governor of the Bank of England has unequivocally argued, it can certainly reject such a union. The Yes campaign says that r-UK would change its mind after polling day, because this would be in the interests of r-UK itself. But that seems most unlikely.

This may not matter much, because Scotland could simply opt to use sterling as its currency in any event, just as Panama uses the US dollar without any formal arrangement with the US monetary authorities. But would this form of “sterlingisation” really be in Scotland’s interests? It would involve abandoning two policy instruments that are seen as crucial by most independent nations – domestic monetary policy and foreign exchange rate policy.

Scotland after independence would remain far more dependent on its energy sector than r-UK, so it will be subject to differential economic shocks as oil prices change. It needs to retain the ability to alter interest rates and the exchange rate in such circumstances.

A more viable alternative would be for Scotland to create a new currency and central bank of its own, and then fix its exchange rate against sterling. Denmark does exactly that against the euro, an arrangement that works fairly well. In extreme economic conditions, Scotland could devalue its exchange rate and reduce interest rates, so it would not find itself in the same trapped position as countries like Spain inside the euro area.

However, in the absence of capital controls, Scotland’s exchange rate would only remain stable if it commands market confidence. Would that be the case?

There are certainly some reasons to be optimistic. Scotland’s economy is structurally very similar to England’s and there is no obvious reason to expect higher inflation, or lower productivity growth, north of the border.

While oil prices remain high, Scotland’s balance of trade would be in good shape, and its public debt ratio would be similar to r-UK’s at 86 per cent of GDP, assuming an equitable apportionment of the UK’s current outstanding debt.

The problem, however, is that the medium term future for government borrowing in Scotland could be worse than in r-UK. This is because of the unwritten accommodation that has arisen between Scotland and r-UK for the handling of North Sea revenues in the last few decades. This has resulted in Scottish public expenditure per capita running 11 per cent higher than in r-UK.

Essentially, the oil revenues have accrued to the UK Exchequer, but recently they have been largely recycled to Scotland as a result of the Barnett formula within the UK budget.

As a result of this accommodation, Scotland is running a budget deficit of about 14 per cent of GDP, with much higher levels of public spending per capita than apply in r-UK. In the event of independence, Scotland would need to receive 80-90 percent of today’s total UK oil revenues, as indicated by its “geographical” share, in order to reduce its budget deficit to 8 per cent of GDP.

That may be achievable, though the international legal issues may be disputed by r-UK during a messy divorce. But the real difficulty for Scotland would arise when oil revenues decline sharply. No-one can be sure when this will be, but Alex Salmond has been much more optimistic on this than the major oil companies, the Office for Budget Responsibility, the Institute for Fiscal Studies or the majority of private forecasters.

Whenever oil revenues decline, an independent Scotland will face the need to raise taxes or cut public spending by many percentage points of GDP, or face a rise in its government deficit that will look unsustainable to international bond investors. Inside the UK, the adjustment would be smoothed or avoided altogether, because the impact of declining oil revenues would in effect be spread across an economy that is 11 times as large as Scotland. With independence, a much more abrupt, forced adjustment would be likely [2].

At the end of the day, there is no reason to believe that Scotland could not balance its books, just as England can. But there seems to be a belief in this campaign that Scotland would find it easier to sustain the National Health Service and its public education service as an independent nation. Actually it could be the other way around. Higher public spending in an independent Scotland would be sustainable only if it was willing to pay much higher tax rates after oil revenues subside than the tax rates paid in r-UK.

Polls today suggest that 46 per cent of the Scottish people are concerned that after independence the Scottish Parliament would not be able to meet its obligations. That is why it could be difficult to achieve the confidence in the exchange rate regime needed to make a “Denmark solution” to the currency problem feasible. Without confidence in the exchange rate, there could be an outflow of deposits from Scottish banks that would sharply tighten credit conditions in Scotland, possibly before full independence takes effect in 2016.

All these economic channels are therefore linked to the fiscal question. With a willingness to accept a medium term rise in tax rates as oil revenues drop, confidence in a new Scottish currency could be achieved, and there would be less risk of an early capital outflow.

But Scotland has always had tax raising powers under the present devolution settlement, and has never yet used them. It may be no easier after independence.

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[1] To declare an interest: I write as someone who has current plans to increase personal investments in Scotland.

[2] A key question is whether the Barnett formula within the UK would survive as oil revenues decline. I assume that it would, at least for a time. See the debate following this informative blog by Simon Wren Lewis.

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