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.

Beware of Economic Gales

Winter gales are nothing new on Sliabh Mannan. On those parts of the moor where the soil is heavy clay, tree roots tend to spread along the surface rather than penetrate downwards. It is never a great surprise when I go out to walk my dog after a gale to find some woodland giant blown over intact, with its root system now forming a vertical wall at the windward end.

Having no great depth of root might be seen as a metaphor for the Scottish economy. We are heavily dependent upon a fairly restricted range of industries, notably oil and finance. When times are good for these industries they can be very good. Basking in the glow of high employment and government revenues from profits taxes, it is tempting for non-economists to be seduced by propaganda assuring them that Scotland is one of the richest countries in the world and could be a Utopian society if only we were independent.

Following the financial crash of 2008 we now see the oil price crash of 2014-15 and the announcement of redundancies in the oil industry. Nevertheless the Scottish government continues to demand a form of Devo-Max under which we should become dependent upon our own highly volatile taxation resources rather than insulated from economic gales by a continuation of the present UK funding arrangements.

It seems to me that members of the Scottish government would benefit from taking a trip out to Sliabh Mannan and learning the lesson of our fallen trees.

Goodbye Primrose Path

If you see a friend walking towards the edge of a cliff whilst playing a game of blind man's buff, what do you do? Call out a warning, I expect.

You might well be surprised and upset when your friend shouts back, "Scaremonger!" and continues to walk forward.

"No really, there's a cliff!" you call.

"Disgraceful negativism!" he replies, sticking his fingers in his ears and starting to hum "La,la,la - can't hear you!"

Separatists amongst Scots seem to believe that as long as you dress up market forces as pantomime villains and hang a sign round their necks labelling them 'English Tory Scares' you may safely ignore them. Economic laws do not apply in the land of Braveheart.

But isn't it really going a bit far to respond to relocation decisions from major financial institutions by continuing to shout 'Scaremonger'?

Just what counts as economic evidence if capital flight does not?

People who don't trust what might happen at the ballot box are voting with their wallets.

It might be a good time to remove the blindfold and take a look ahead.

Scottish Monetary Policy

If Scotland continues to use sterling despite no longer being part of a currency union, we will have no choice but to accept whatever monetary policy the UK decides upon.  There are 58 million in the UK and 5 million of us.  They will have no more reason to take account of a foreign Scotland when determining their monetary policy than the USA has to take account of Panama when determining theirs.

Deduct the forty odd Scottish Labour seats and the chances are that the next UK government is Conservative.  They will implement Conservative monetary policy in the UK and that policy will apply in Scotland because Scotland will not have its own monetary policy.

Perversely this means that, so long as Salmond’s Currency Plan B remains the use of sterling without agreement,  voting 'yes' in the referendum results in the imposition of a Tory government's monetary policy in Scotland.

Perhaps this is what he means when he promises that Scotland will get what it votes for.

No-one can stop us!

"No-one can stop us using the pound!"

That is true. No-one could stop us using the dollar or the yen either, if we chose to do so. It just wouldn't be smart. Neither would using the pound outside the UK currency union.

No-one can stop Panama and Ecuador using the dollar, so they do use it. But the dollar is a foreign currency, controlled by a foreign country. These two Latin American countries allow the USA to enforce fiscal and monetary discipline upon them because they can't easily do it themselves. They have to generate trade surpluses in order to accumulate domestic spending power. Their governments are not masters of their own economies.

So if Scotland wants to wrest control of monetary policy away from London only to hand it straight back again, this time with no influence over it whatsoever, then yes, no-one can stop us.

On the other hand, good luck generating the trade surplus needed to pay for the promised fairer society after the financial services industry has been forced to move south of the border in order to stay in the same jurisdiction as its lender of last resort. Most Scottish financial products are exported to the UK.

Good luck obtaining a fair share of The Bank of England's foreign currency reserves after you've refused to take a fair share of the UK national debt.

Good luck finding people to purchase Scottish government bonds when you've shown yourself likely to default whenever you don't get what you want.

But we can always console ourselves with the thought that no-one could stop us!

Scottish Referendum:Currency Plan B (for Broke?)

This is the text of my letter,  published in The Falkirk Herald last Thursday:

"It's Scotland's pound and we're keeping it," they say. We are still being treated like children who do not understand economics.

The pound is the currency of the union. It is not Scotland's pound, nor is it England's, Wales' or Northern Ireland's pound. Scotland proposes leaving the union. You cannot divorce and expect to retain the joint account. When you're single again you must establish your own account and pay your own way.

It's no good repeatedly telling your ex-partners that it's somehow in their interest to continue underwriting your debts; after the 2008 crisis they won't believe you.

If Scotland used the pound unilaterally we would have to accumulate pounds by trade, since our government could not create for itself an increased supply of a foreign currency. Failure to generate a trade surplus would thus preclude the blithely promised fairer society. You might want it, but you can't have it if you can't pay for it.

Without a central bank, borrowing would become more expensive, especially if the Scottish government followed through on its reckless threat to throw over responsibility for its share of the UK National Debt. Remember a Scottish Chancellor under a Scottish Prime Minister recently increased that debt to rescue The Royal Bank of Scotland. No-one lends cheaply to those perceived as defaulters.

Loss of financial sector jobs could easily run into tens of thousands, reducing tax revenues, increasing the Scottish government's need to borrow and raising interest rates still further.

Using sterling without agreement has costs. It's not just a matter of thumbing our noses at the rest of the UK and saying we'll do as we like.

Currency unions are like joint accounts

I really did not intend to devote so much space on my blog to the economics of Scottish independence.  I feel obliged to do so because political spin doctors have been engaging overdrive in an apparent attempt to obscure the issues and reduce popular understanding. I have no problem with people making an informed choice.  I do have a problem with people being misled.

In my letter published in yesterday's Falkirk Herald I used the same metaphor that I have previously used on this blog.  When I compare a currency union to the joint bank account of a married couple, I do not of course mean to suggest that they are the same thing, merely that they have a number of helpful similarities.

Not many non-economists have a clear grasp of the nature of currency unions.  Indeed the history of the Eurozone suggests that either a fairly substantial number of economists did not understand these principles either, or that political confidence overwhelmed economic objections.  The disparate economies that were enclosed in the straitjacket of the common currency were simply not sufficiently closely aligned.  A certain number of conjuring tricks were employed to make the figures look reasonably convergent in the qualifying year, but everyone should have realised that the important issue was not the statistics but the underlying reality.

A decade of growth camouflaged the problem; it did not make it go away.  The long rolling series of near defaults was always going to happen. The fact is, that  two divergent macroeconomic policies cannot be accommodated within a single currency zone.

Non-economists will, I hope, find the problem simplified by my analogy.  Like our divorcing couple separating their bank accounts in order to prevent one party from spending the other's money, two countries each need their own currency in order to operate any approximation to an independent monetary policy.  The Eurozone went for the joint account first and  loveless political marriage seems bound to follow if they will not reconsider their mistake.

Scotland is a tenth of the size of the UK and any currency union between the two would never result in her being able to underwrite UK debts.  The UK would have no partners in underwriting Scotland.  In return for taking on unlimited liability the UK is offered freedom from exchange costs that at most would amount to a little more than 1% of what it cost the UK to bail out RBS alone.  Can anyone seriously claim that represents a good deal for the UK?

There is no economic justification for divorcing London in order to marry Berlin.  The Eurozone is going to tighten its political integration.  Unofficial use of sterling can only be a short term stratagem since it would deprive Scotland of any effective monetary policy at all. 

Independence means a new Scottish currency.  There.  It wasn't so hard to say it after all.

Scotland's Currency Options

There has been much talk of the four currency options for an independent Scotland. Much that I have seen suggests that not everyone understands what the options are, let alone what advantages and disadvantages each has. Perhaps, leaving aside political issues for the moment, I might be allowed to outline them.

1. A sterling currency union means that both the UK and Scotland continue to use the pound by agreement. Between two economies of such unequal size as Scotland and the UK such an arrangement has little to recommend it except familiarity, (which was not enough to preserve the currency union of The Czech Republic and Slovakia after their political split.)

• It is not possible for a single central bank to operate two monetary policies. Market forces would oblige the central bank to pursue the monetary interests of the larger partner, even if political factors did not.
• Likewise neither partner could pursue an independent fiscal policy, because each government's borrowing would increase the common money supply. Agreement would be required.
• The UK would therefore have to cede a degree of its own monetary independence to Scotland. It has previously resisted doing this for the Eurozone, which is a much bigger market.
• An additional disadvantage would be each partner taking on an obligation to underwrite the finances of the other without the multinational burden sharing that is possible within the Eurozone.
• This is the option that the UK has ruled out. There are good economic reasons for ruling it out and no advantages for the UK that would come near to compensating for the loss of independence.

2. Informal use of sterling by Scotland means Scotland continuing to use the pound without the UK's agreement. This is the kind of arrangement used by Ecuador and Panama in respect of the dollar. It could not be prevented by the UK. It would avoid the introduction of exchange costs for trade within Britain, but is far from meaning that nothing would really change. Effectively it would take most of the so-called 'levers' of economic influence out of the hands of the Scottish government.

• It would not allow Scotland to create its own money supply.
• It would prevent a Scottish central bank from operating a meaningful monetary policy.
• Although this would also remove the need for UK government agreement of Scotland's fiscal policy, the same sort of constraints would be imposed instead by the need to obtain sterling through trade etc.
• It would remove the guarantee provided by the UK underwriting Scottish finances. This would imply a higher government borrowing rate for Scotland.

Thus neither formal nor informal currency sharing would allow a great deal of economic flexibility to the Scottish government.

Both formal and informal currency sharing would remove from the Scottish government's economic armoury the possibility of adjusting its exchange rate with the UK in order to absorb any imbalances that might develop.

3. A new Scottish currency is the only other option likely to be immediately available to an independent Scotland.

• This has a lot of short term costs and risks, including the introduction of exchange costs with the UK.
• However a more serious problem would be the need for the new currency to be underwritten by a Scottish government with no track record of debt management and which has incautiously flirted several times with the option of not taking on its share of UK National Debt. Possible lenders will remember perfectly well that a lot of the UK debt was incurred in bailing out Scottish banks and threats to walk away from responsibility for that debt can only raise the cost of borrowing by an independent Scotland.
• It might take some time to reassure foreign exchange markets that the new currency was 'hard', (i.e. it can be trusted to hold its value.)
• The new currency would also be a 'petrocurrency', (i.e. volatile and vulnerable to oil shocks.)

4. Joining the Eurozone is not a immediate option, because the entry conditions require two years' stable management of the domestic currency, a qualification which a Scottish government would lack. There may or may not be separate problems associated with Scotland's admission to the EU itself.

• It needs to be borne in mind that the Eurozone is just another currency union and that Scotland would be even less influential within this much larger zone than it would be in a sterling zone.
• Effectively monetary policy would be determined centrally and fiscal policy would be subject to the EU's Stability Pact.
• Even this has not been enough to preserve stability in the Eurozone of late and it seems likely that more political integration within the zone will be required in order to cement the stabilisation of the Euro as a currency.

Those, very briefly are the options. None of them are as advantageous as the present arrangement, but of course the present arrangement cannot be combined with independence.

Bailing Out Other Countries

Some people perceive double standards between the UK's bailout of Ireland in 2010 and its disinclination to accept a sterling currency union that would include an obligation to bail out an independent Scotland.

The economic logic is actually straightforward. Ireland belongs to the Eurozone. In 2010 the UK contributed about £7b of an EU rescue package of around £85b, in the process extracting the concession that it would not have to bail out Eurozone members again.

In a prospective sterling currency union of two, the whole of the burden of bailing out one partner would fall upon the other. There would be no obligation on EU members to contribute, any more than they contributed to the £46b UK bailout of RBS.

There is one other big reason for the UK not wanting to share sterling. The Bank of England cannot operate two monetary policies. For example, it could not simultaneously create a stimulus in Scotland and apply restraint in England. Money would simply flow between the two.

It is Scotland that is proposing to leave the UK, not vice versa. There are ten times as many UK Citizens outside Scotland as inside. There is no reason for them to let us take away with us a piece of their economic independence.

Scottish Debt

The only surprising thing about the UK Treasury statement that it will honour all UK debt, including Scotland's notional share, in the event of Scottish independence is that the statement needed to be made at all.

A gilt-edged security certifies a contract between a lender and the UK as a sovereign borrower. A contract cannot be unilaterally amended by one of the parties.

It is fair criticism to say that I should not have used the word default in my articles on this subject back in November, since that word might be understood as suggesting that the lenders risked not being repaid at all, rather than not being repaid by the beneficiary. Legally the UK government is responsible for its borrowing, irrespective of whether the whole of the UK or only a part is in receipt of the resultant spending.

The point that I made in November is still valid. The divorcing partner who refuses a fair share of the joint debt behaves immorally. Suspect behaviour raises the spectre of default in the collective mind of the market and that raises interest rates for the irresponsible partner's future borrowing.

Scotland and The National Debt

Alex Salmond has once again (19 November) threatened that non-compliance by the rest of the UK with his demands to 'share' sterling and The Bank of England after Scottish independence could lead to Scotland refusing to accept its share of the UK national debt. I realise that this is campaign rhetoric. It is nevertheless misguided.

The markets are listening.  They want to know what to do if they have to deal with an independent Scotland in the future.  The more likely a ‘Yes’ vote becomes the more they will trawl through the backlog of such remarks for guidance on future Scottish financial policies.  They will not like what they find.

Let us be clear. There are three important reasons why this demand is misguided.

1. Firstly, sterling is not an asset it is a national currency.  A currency is a claim on goods and services within an economy; it is not itself a good or a service. I have already explained in an earlier article the problems that are likely to face an independent Scotland that seeks to share a currency with its much larger neighbour.
2. Secondly, The Bank of England is the official banker to the UK government and an instrument of UK monetary policy.   Although its terms of reference are laid down by UK law, its independence from direct UK government control has been guaranteed since 1997.   Scotland is seeking to leave the UK. SNP ministers claim to want control of the economic levers for themselves. In what way would this purpose be served by 'sharing' an institution that does not take orders from government?
3. Thirdly, and most importantly, governments must never suggest defaulting on debt.  They must not imply it, or hint at it, or say anything that may be misinterpreted as an implication or a hint.  Everything that a First Minister or Finance Minister says is market sensitive.

The reason is that governments always need to borrow money.  Even governments running a surplus on the budget need to borrow money, because, just like you and me, the timing of their income does not coincide with the timing of their payments.  People who lend money to governments are sensitive to anything that makes them the tiniest bit afraid they might not get it back.  Every such unguarded remark could add half a per cent or so the Scottish Government's borrowing costs after independence.

We may end up with a Scottish currency whether we like it or not, for reasons outlined in my earlier article.  In any case, foreigners will have to hold Scottish paper with confidence.  The more suggestions there are that Scottish ministers don’t understand the markets and are careless or glib with financial pronouncements, the more reluctant foreigners will be to hold Scottish currency or bonds.  Scottish interest rates will have to rise to compensate for this perceived increase of risk.  In consequence, Scottish investment will become more expensive and therefore Scottish economic growth will fall. 

Is a point or two in the opinion polls today worth a point or two on the Scottish government's borrowing rate for years to come?