By Ronald MacDonald, Adam Smith Professor of Political Economy
The long awaited White Paper setting out the SNP’s stall for an independent Scotland revealed key inadequacies in its thinking on a range of economic issues, from the currency to fiscal policy. The issue of the currency especially seems to have become the defining issue in the independence debate.
Many had hoped that in their White Paper the SNP would offer a well thought through plan B on the currency. An alternative to plan A, a continued sterling monetary union post-independence, is urgently needed since as I and others have pointed out it suffers from huge problems. Unfortunately no mention is made of a plan B in the recent White paper. Why? The key element in the White Paper used to justify the continued use of sterling post-independence is that productivity levels in Scotland and the rest of the UK (rUK) are currently very similar. That much is correct. On that basis, the First Minister in presenting the White Paper stated that Scotland and rUK represented an ‘optimal currency area’ and therefore a sterling zone was the most appropriate way forward with respect to a currency zone.
However, it is well known in the Economics literature that a similar level of productivity is only one criterion that would determine an optimal currency area between Scotland and rUK – there are many others, few of which Scotland and rUK would satisfy. The biggie is, of course, the hydrocarbon effect that would effectively make any currency union with the rUK untenable from day one. Yet this is nowhere discussed in the White paper and did not even get the slightest mention in the First Minister’s launch speech although, of course, oil revenues are absolutely central to the rest of the SNP’s narrative about Scottish independence.
But putting aside oil and focussing in on the productivity angle alone, we see that this in itself blows a huge hole through the currency plans sketched in the White Paper. The reason that it is good news that Scotland and rUK have similar levels of productivity is that if they had divergent levels this alone would render a sterling zone unviable, because it would imply competitiveness changes inconsistent with a sterling monetary union. Yet, in their response to the IFS report on the Financing of Scottish Government, the SNP made much of how they would use the so-called levers of economic independence to grow the Scottish economy and improve productivity.
If they were successful then of course this would, render a monetary union untenable from day one of independence. Why day one, since surely such productivity gains would take some time to work through? The sterling zone would be untenable from day one of independence, or more likely a long time before independence, because financial markets are forward looking. They bring inconsistent economic policies of governments to grief sooner rather than later. How would this process actually work in practice?
If Scotland were to become independent it may inherit a proportion of the UK’s national debt although even if it had not, it would still have to issue debt to finance its fiscal deficit, which would most likely be in the region of 5-6% of GDP post independence. That debt has to be sold on open financial markets. Again it is now widely accepted that an independent Scotland would incur a premium on its debt (i.e. a higher interest rate), which is simply in the nature of small countries with shallow capital markets, especially new ones. This premium would be determined by financial markets but is likely to be in the region of 1 – 2% above what HMT would have to pay on similar UK debt.
However, the 1-2% premium is predicated on an independent Scotland having a credible currency arrangement and, indeed, wider macroeconomic framework in place. As things stand at the moment, the proposed currency system is not credible and international capital markets would require such a huge premium on and independent Scotland’s debt that its deficit would be unsustainable and the Scottish Government would be forced to make significant cuts to public expenditure, or raise taxes or both and abandon its exchange rate policy at huge cost to the Scottish economy.
Of course, even before the first day of independence individuals and business would have an 18 month transition period to move capital out of the Scottish economy if there are clear uncertainties arising from its currency policy. Attempts by, for example, key elements of the Scottish Financial sector to locate some (perhaps in proportion to its trade with rUK) or all of its business south of the border, could have massively profound effects on the Scottish economy in terms of employment and output.
So with no well thought through plan B in place the outcome of a Yes vote would produce a very uncertain time for the Scottish economy, with likely massive disruption to employment and output which would be generational in its impact, just as in the case of previous economic mismanagement of UK exchange rate policy.
Their also seems to be an important misperception in the recent White Paper, and in statements by prominent figures in the SNP, that the UK would have to sign up to a sterling zone arrangement because the balance of payments consequences of not doing so would be unpalatable for rUK. However, it is widely accepted that sterling is currently overvalued. Much of this comes from the effect of North Sea oil revenues on the UK balance of payments. Freeing the UK from this burden would make the UK much more competitive but have the opposite effect on the Scottish economy. This is surely not a very good bargaining position for the Scottish government?
Without a plan B, then, on the currency issue the Scottish public are effectively being duped about the potential massive costs and disruption to the Scottish economy. Such costs and disruption are likely to be generational in their impact as has been the case in Scotland and elsewhere from the Thatcher government’s experiment with monetarism in the late 1970’s/ early 1980’s and the consequences this had for the sterling exchange rate. Is history going to be repeated?