Saturday, 30 May 2015

Sum You Lose

The recent electoral success of the SNP throws the spotlight back on the question of Scottish independence. It seems few people remember that the economic forecasts of the nationalists were discredited within months of last year's referendum. Perhaps therefore a summary of the crucial points might be appropriate.

In December 2013 The SNP published Scotland's Future, a document long on words and short on numbers. Yet amongst the numbers it did contain, one received surprisingly little attention. It was projected that in the first year of independence the Scottish fiscal deficit would be £4.4 billion, or approximately £1,000 for every adult member of the population.

Remember that figure, it is important. At a time when people were blithely talking about being one of the richest countries in the world, creating a more caring society and setting up an oil fund for the benefit of future generations, the numbers actually showed that Scotland was already living beyond its means and proposed to go even further into debt.

In order to arrive at this deficit figure, they made assumptions about likely sources of government revenue. Large receipts were expected from taxes on Scotland's oil and finance industries, which together form a disproportionately large component of our national income. Assumptions were also made that Scotland would continue to use the pound sterling as its currency and that Scotland would run a Balance of Payments surplus. All four of these assumptions were flawed.

Official statistics were pessimistic about future oil prices, given the threatened slowdown of the Chinese economy and the rapidly expanding supply of cheap shale gas from the USA. Alleging deliberate manipulation of the figures to disparage the potential riches of an independent Scotland, the nationalists substituted their own oil price estimate (of over $110 per barrel). In fact the official statistics turned out to have been over-optimistic. In 2015 oil prices are in the range $50 to $60, around half the nationalist projection. So far from supporting an independent Scotland, the oil industry was soon in need of UK government help.

The UK Chancellor of the Exchequer challenged the assumption that Scotland would continue to use the pound sterling. He expressed himself poorly. What he meant to rule out was a currency union by which the rest of the UK would continue to underwrite Scottish finances. Fresh from the 2008 banking crisis in which UK taxpayers had been required to find £46 billion to bail out Royal Bank of Scotland, that was hardly surprising.

His lack of clarity was misrepresented as a threat. "No-one can stop us using the pound," Alex Salmond declared. This was of course true. Surprisingly he did not go on to explain that no-one could stop us using the dollar or the yen or the Zambian Kwacha either.

An independent country may use any foreign currency it likes, provided it can get hold of enough by means of a trade surplus. Panama, for example, uses the US dollar. All that you have to do is give up any desire to control your own monetary policy. If Scotland were to use the pound without a currency union it would have no choice but to accept UK monetary policy as its own.

It also means the Scottish government could only run a fiscal deficit to the extent that it could cover the revenue shortfall with reserves of sterling.

An odd sort of independence, you might think, that resulted in less economic powers than Scotland already has?

When the currency problem became clear, the large Scottish financial institutions announced plans to move their services to UK customers south of the border. This was not simply a brass plate technicality to comply with EU regulations as nationalists claimed.

Banking profits derive from the difference between the interest rates at which banks can borrow and those at which they can lend. Essentially a bank's lending operations create new money and most of the money supply in a modern economy consists of bank deposits, not cash. In order to perform these money-creating operations, banks must be within the jurisdiction of, and accept regulation by, the central bank responsible for that currency. A bank attempting to create new foreign currency would be acting illegally; it can only operate in a foreign currency to the extent that it possesses reserves of that currency.

The net result of this alleged technicality would therefore be twofold.

      1. Scotland's financial institutions would be responsible to the Bank of England and pay their taxes to the UK Treasury.

      2. Without financial exports it is unlikely that Scotland could run a Balance of Payments surplus. This would eliminate the Scottish government's ability to acquire reserves of sterling and thereby to run a fiscal deficit.

Now please remember the important figure that I quoted at the beginning of this article. By the SNP's own projections, the fiscal deficit in the first year of independence was to be £4.4 billion.

This was before accounting for the fall in the oil price and the loss of the financial services industry. It was before losing control of monetary and overall fiscal powers as a result of sterling becoming a foreign currency. This £4.4 billion deficit was actually a serious underestimate, perhaps not within several orders of magnitude of the reality.

Not only would a future Scottish government be unable to afford the promised fairer society, it would have to borrow improbable sums just to keep public spending at present levels.

Why improbable? Because in order to borrow you must first establish that you are creditworthy. Why might the international financial community suspect that Scotland was not creditworthy? Because the SNP threatened that if they did not get their own way on the currency they would walk away from responsibility for Scotland's share of the UK National Debt.

Let us leave aside whether one could throw over this debt without sacrificing Scotland's claim to a share of the national assets and infrastructure which that debt has financed, much of which is not located in Scotland and nearly all of which would need to be replaced by an independent country starting from scratch.

Let us also leave aside the fact that a country involved in a major financial dispute with an existing EU member would struggle to find an easy path to re-joining the EU.

Just consider this single point. What international lenders would offer reasonably priced funds to a new government whose first independent monetary act had been to deny any responsibility for debts accumulated jointly under the previous political union?

I am an economist. But of course I am also human. I might be wrong. To persuade me that I am, would enthusiasts for independence please not shout at me. Just show me your numbers.

And before you do, please check that they add up.

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