Is an independent Scotland economically viable? In the first of two New Left Project exchanges ahead of Thursday’s independence referendum, prominent economic commentators James Meadway and Frances Coppola debate the merits of a currency union and the likely economic consequences—for the rest of the UK as well as for Scotland—of Scottish independence.
- James Meadway JM was a policy advisor at HM Treasury and is senior economist at the New Economics Foundation. He writes here in a personal capacity.
- Frances Coppola FC is a writer and commentator on economics and finance. She is associate editor at Piera and contributes to Forbes.
James opens, followed by Frances, then a response from James and a concluding response from Frances.
The past week has seen, for the first time, opinion polls showing support for Scottish independence inching just ahead of opposition. This has provoked the most extraordinary panic from London. Labour MPs have been dispatched to Scotland in their dozens. David Cameron, Nick Clegg, and Ed Miliband have all made earnest appeals for Scotland to, in David Bowie’s phrase, ‘stay with us’. The flipside of this lovebombing has been a concerted campaign to convince Scottish voters of the economic calamity that will befall them come independence.
Considered dispassionately, this makes little sense. An independent Scotland would be a small, north European country with a population somewhere between Denmark and Norway. It would be rich, with a GDP per capita comparable to Finland’s, including the oil revenues. It has substantial infrastructure, excellent education provision, and its own legal system. It currently contributes more in taxes to the UK Exchequer than it receives. It has a long history of self-rule, and a recent history of largely popular devolved government. There are no convincing reasons to think this country would fail, and plenty to think it would succeed.
The ballyhoo, if it is to convince at all, has to work against the Scottish economy’s underlying strengths, and talk up its weaknesses. To do so, it has to turn recent history on its head, and pretend that the global ‘instability’ Scotland should so fear under self-rule can only be warded off by remaining under the protection of the British state.
This is nonsense. We have lived, in the last few years, through one of the deepest recessions in this country’s recent history, after the crash of 2007-8. That financial crash was exceptionally severe in the UK: the size of its bailout, at 100% of GDP, dwarfed that of any other country. We are still paying for this now, through the burden of austerity. And yet very little of substance has changed since then. The UK’s much-trumpeted ‘recovery’ is based, still, on declining real incomes for most people alongside a return to a spectacular London housing bubble and rising household debt. This is very clearly unsustainable; indeed, economic modelling by Dr. Jo Michell suggests it cannot realistically be sustained beyond 2018 or so.
These are not external factors. They are a direct product of the UK’s financialised economy, centred on the City of London. And this economy has a dirty secret—the UK’s dismal current account. We have run a deficit in international goods trade every single year since 1983. Even including our trade in services, the deficit last year stood at 4.4% of GDP. The UK has financed this by borrowing from abroad, to the point that we now have the largest external debt of any major developed economy, at 406% of GDP.
This is the deficit that exists even with North Sea oil. Export revenues from the North Sea ran at nearly £40bn last year, and virtually all of this comes from oil pumped in Scottish waters. Absent this Scottish oil revenue, the current account deficit potentially lurches from 4.4% of GDP to 6.9%. It is one thing to run a 4-5% current account deficit, year in, year out, and expect the rest of the world to pay for it. It is quite another to expect a deficit of (potentially) close to 7% of GDP to be covered so easily.
Scotland has no such difficulties. With a geographical share of the oil, it would run a comfortable current account surplus. With RBS and Lloyds offering to move their headquarters south to London, it no longer faces the potential headache of bailing these bloated zombies out.
Simply put: it is the UK that is the high-risk economy, not Scotland. And it is worries over the UK and its current account, as the Financial Times alluded to, that are helping stoke market tremors.
I’m stressing these economic fundamentals because they determine outcomes over the longer-term. And if independence really is a once-and-for-all decision, it’s the longer-term that matters. The oil may well run out by 2050, as some have claimed; frankly, if an independent Scotland can’t organise a transition out of a dependency on oil over 36 years, it’s got bigger problems than a few wobbles in the oil price. A break with the UK’s ‘intellectually bankrupt’ oil tax regime, which saw some £74bn in revenues squandered during the boom, would certainly help here.
The difficulties lie in the transition to independence. But this, if it happens, will be the subject of negotiation. Currently, the SNP wants a currency union. Westminster, arrogantly, has ruled this out and refused to offer its own post-independence plans for the future—no doubt further rattling financial markets. The advantages to having an independent currency are substantial, and certainly greater than remaining tied in to use of the pound, with the Bank of England setting monetary policy across the whole island. If anything, it is the remaining UK that would benefit most from such an agreement. But that is the point: a currency union, formalised, with agreements on the degree of fiscal flexibility allowed, would be a simple extension of current arrangements, rather than some horrifying new thing. It wouldn’t be complete independence; but it would be very significantly more than is available now.
The risks from Scottish independence lie with the UK, not with Scotland. Our economy is dangerously imbalanced. Scotland has the option of marking out a different course; we, in the rest of the UK, should do the same.
I share your concerns about the UK’s trade deficit, and I also agree that the UK economy needs rebalancing. But this debate is about Scotland. The financial and economic case for Scottish independence cannot rest on the problems of the UK. It must stand or fall on the costs and benefits to Scotland.
The economic case for independence that you outline hangs principally on your assertion that Scotland would have a ‘comfortable trade surplus’ due to North Sea Oil. This is very unlikely to be the case.
According to Scottish National Accounts Project (SNAP) statistics, Scotland’s non-oil goods and services trade balance has been persistently in deficit to the tune of about 7% of GDP for the last 15 years. Adding in Scotland’s geographic share of North Sea Oil brings the trade balance to an average surplus of around 2% of GDP:
The Scottish government expects North Sea Oil receipts to increase significantly, which would of course lift the current account balance above zero. But the trade balance spikes in 2008 and 2011-12 are deviations from trend due to exceptional conditions in global oil markets: revenues from North Sea Oil have now fallen back to their long-run average and there is no reason to assume that they would rise to a persistently higher level. A prudent forecast would maintain the long-term trend rather than relying on optimistic projections from oil companies.
In a report on lender of last resort options, from which the above chart is taken, the National Institute of Economic and Social Research (NIESR) estimates Scotland’s current account balance after net factor income flows as being approximately zero, not positive as you suggest. It also observes that as a significant proportion of Scotland’s businesses are owned by the rest of the UK, income flows are likely to be substantially in deficit post-independence. ‘Much depends’, it concludes, ‘on the size of Scotland's financial sector after independence’.
Exports of financial services make up 15% of Scotland’s exports and about 9% of its GDP, and the vast majority of this comes from the three largest banks and the insurer Standard Life. All of these have now declared their intention to move their headquarters south of the border in the event of a ‘Yes’ vote. Loss of these four would by itself turn a 2% trade surplus into a 7% trade deficit. If other businesses relocated too, the trade deficit would become even bigger. With income flows in substantial deficit and North Sea Oil revenues at their long-term average, it looks as if Scotland is facing a current account deficit of at least 10% of GDP after independence.
It is not reasonable to dismiss the statements of RBS and HBOS. These two banks have no choice but to move south on independence, since the majority of their business is in England & Wales and under EU rules banks are required to domicile themselves in the country where they do the majority of their business. The UK’s Prudential Regulation Authority would also be likely to insist on this.
Turning now to the fiscal position, a fiscal deficit in 2016-17 of the order of 6.8% of GDP has recently been forecast by the Centre for Economics and Business Research. This is somewhat higher than the Institute for Fiscal Studies' (IFS) forecast of 5.5% of GDP for the same period, because it takes into account the recent sharp fall in North Sea Oil revenues. However, even if you accept the lower IFS figure, covering this deficit and the additional costs of independence would require Scotland to borrow, most likely at an interest rate significantly higher than either the rest of the UK (rUK) or members of the Eurozone, since it would have no credible central bank backstop and would be running large twin deficits. This situation would apply whether or not Scotland accepted its share of UK debt, though obviously its fiscal deficit would be slightly lower with no existing debt to service. I should also point out that a deficit of 5.5% of GDP is too high for Scotland to be accepted as an EU member: it would be forced to adopt austerity measures to bring the deficit down in order to meet Maastricht criteria.
Given the likely weakness of Scotland’s economy post-independence, the refusal of Westminster political parties to consider currency union looks not arrogant, but sensible. If the SNP continued with current spending plans, the rUK would have to provide an implied fiscal backstop in order to protect sterling, as the Eurozone has been forced to do with Outright Monetary Transactions (OMT). It is by no means clear that the benefits to the rUK of doing this would exceed the risks. But all the post-independence currency alternatives look grim. A recent report by Professor Macdonald of Glasgow University explains that all the alternatives would require Scotland to run fiscal surpluses for some years after independence in order to build up foreign exchange reserves. Unless by some miracle North Sea Oil were to ramp up to 1980s levels again, this would involve spending cuts and tax rises on a scale far greater than anything experienced under the UK’s Coalition government. I do not want to see such pain inflicted on the Scottish people for the sake of a political dream.
Thank you for the reply. I’m glad we’re both agreed about the parlous state of the UK economy. Where we disagree is on the relevance of this to Scotland’s decision. I think it’s absolutely central to understanding why independence makes sound economic sense: Scotland has the chance to run for the exit. The rest of the UK, unfortunately, does not—although it’s certainly possible that the jolt of Scottish independence may hasten reform down here.
The question of the current account deficit is central here. For the UK as a whole, the current account deficit reached record levels last year. The major culprit in this was a steady decline in incomes from abroad. That decline has now been in train for well over a year. It’s serious, because it means the UK’s deeply globalised economy is no longer producing returns. A slight recovery in net incomes from abroad over the first quarter of this year has not come close to reversing the decline of the last few years. But even if this troubling loss of net earnings from abroad is pulled back, the UK still runs a persistent current account deficit. Without Scotland and Scottish oil revenues, the UK is in a deep mess, as Societe Generale has now also argued.
Scotland, with its healthy oil reserves (even leaving aside informed speculation about West of Shetland and the Clyde), could be insulated from this. You suggest that the (provisional) Scottish National Accounts Project (SNAP) figures imply a Scottish current account surplus of 2% of GDP. Relative to a persistent UK current account deficit of 4.4%, that looks pretty healthy. The threatened ‘loss’ of a few major banks I don’t view as a problem here: relocating headquarters has very little impact on the location of activity, and the bulk of RBS and Lloyds’ activity already takes place outside of Scotland. The bank branches and other services will remain in Scotland on the simple grounds that they make money. The effect on Scotland’s current account will be negligible; frankly, if these two zombies decide to take their HQs elsewhere, this is a net gain for Scotland in that it will no longer face the potential bailout costs, previously trumpeted as a decisive barrier to independence.
That is on the private sector side. For the public, you cite the IFS’s estimate of the government deficit. Like the rest of the UK, Scotland plunged into a deep deficit as a result of the financial crisis. That legacy will be with it whatever the outcome of the vote. But the scale of the deficit here will be political: given current disputes over the allocation of public debt to a newly-independent Scotland, I don’t share the IFS’s certainty over the size of that deficit, since that will also depend on the size of interest payments and debt repayments. But even with a deficit of 5.5% of GDP, market financing for an oil-rich state with a stable legal system should not be an issue, particularly if the headache of the zombie banks has been removed. And a Scotland with tax-raising powers would be perfectly free to do just that, and raise taxes; I don’t share the SNP’s enthusiasm for corporate tax cuts, for example, and I think far more of its oil wealth should be returned to the people of Scotland, rather than the oil majors. That is, however, for Scots to decide.
On the basis that it will not want to either push up interest rates or allow sterling to collapse in value, having lost the oil exports, I would expect the UK to agree to a currency union. Irresponsibly, the UK authorities have failed to present any plans on how they will negotiate this. We can’t know what the outcome will be—although Scotland will hold a trump card in the form of its oil reserves. Most likely, it will include an agreement on the division of the public debt, and on foreign exchange reserves. As Joseph Stiglitz has said, the currency union is, essentially, a ‘non-issue’—one we might suspect has been talked up to frighten and confuse Scottish voters.
We have to return, again, to the fundamentals. An independent Scotland would be a small, northern European country with a long history of self-rule, solid educational and legal systems, a diversified economy producing a substantial trade surplus—and one huge, declining resource in its oil reserves, as well as huge potential in its renewables. There are no good reasons to think this economy will fail, if it is not forced to. There are plenty to think it will succeed.
Firstly, I need to make a correction to your piece.
You assert that the effect of the loss of financial services on Scotland's current account will be ‘negligible’. But in a previous sentence you note that ‘the bulk of RBS and Lloyds’ activity already takes place outside Scotland’. Indeed it does, and for that reason the effect of a relocation on Scotland’s current account cannot possibly be negligible. The activities of Scottish financial services companies outside Scotland are currently recorded as exports of financial services in Scotland’s goods & services trade balance. When these banks—and probably the rest of financial services too—relocate, those activities will disappear from Scotland’s trade balance, since they will no longer be Scottish exports. Financial services currently make up 15% of Scotland's total exports—by far Scotland's largest export sector. Their loss would clearly turn the current account balance significantly negative.
Now to the substance of your argument.
Like many people who do ‘shock, horror’ about the UK’s trade deficit, you ignore two things:
- The UK is a net importer of capital (mirroring its current account deficit).
- The EU, to which half of UK exports go, is running a current account surplus.
I shall address each of these in turn.
The economist Stephanie Flanders, in the piece you linked to, points out that the fall in investment income to the UK from abroad is at least partly due to banks reducing cross-border lending. Cross-border lending is a major risk to the banking system, so a significant fall should be taken as a sign that things are getting less risky, not more. The other reason why the UK is a net importer of capital at the moment is its status as a safe haven for investors looking to move money from riskier parts of the world such as Russia, which attracts capital inflows. The inflated nature of the London property market is clear evidence of this. I don't think this is particularly healthy, but it certainly isn’t the catastrophe you portray.
Turning now to the UK’s export competitiveness, the EU is running a current account surplus partly because of low domestic demand in Germany and partly because of the depressed nature of many EU economies. The UK’s poor trade performance is more a reflection of the ghastly situation in Europe than of fundamental domestic problems. It is extraordinarily difficult to export to countries that don’t want to import. Germany succeeds in doing so because it has a policy of persistent wage repression and fiscal austerity: do you really want the UK to go any further down that path than it already has?
In short, although I am concerned about the UK’s trade deficit, I do not agree that it is a looming disaster. Nor, it seems, do markets: gilts are trading at historically low yields, and sterling was if anything too strong until recent fears about Scotland upsetting the apple cart caused it to fall. So I don’t accept your argument that Scotland needs independence so it can abandon a sinking ship. The ship is in turbulent waters, but it isn’t sinking.
You say a currency union is probable, because catastrophic loss of oil revenues for the UK would place sterling at risk. I disagree: the end of Barnett transfers would partly offset the loss of oil revenues, giving a net loss of about £3-4bn per annum for the UK—an insignificant amount for an economy of its size. But supposing you are correct, then why on earth would an independent Scotland want to enter into a currency union with a country which is on the verge of collapse due to an unsupportable debt load and an insanely large trade deficit? That isn't abandoning a sinking ship, it’s tying itself to the mast. Personally I see very little benefit to the UK in a currency union and considerable risk. The benefit is clearly to Scotland in keeping borrowing costs low by hanging on to the shirt tails of a much larger economy with a good credit history—the SNP’s desire to maintain the currency union is thus unsurprising, given the fiscal deficit it wants to run. But Scotland would not be free to run a large fiscal deficit in a currency union: since the larger partner effectively guarantees the borrowing of the smaller, it is bound to impose limits on the smaller partner’s deficit spending. There is no way around it: currency union is not independence.