Liberty for Scotland: the next steps

As the date of the vote for the Scottish Referendum stands firmly on the horizon, John Kay addresses the concrete steps that would need to be considered for a successful economic transition to be a prosperous, independent state in this speech at University of Glasgow.

John Kay, lecturer at LSE. Flickr/Policy Network. Some rights reserved

Many of you will be aware of a poll that was conducted in 2011 in the Scottish Social Attitudes survey. Respondents were asked how they would vote on independence if they could be sure they would be £500 better off. That question produced a 2:1 majority in favour. Then they were asked how they would vote if they would be £500 a year worse off. That question produced a 2:1 majority against.

I have no knowledge of any similar polls being conducted in the United States in the 1770s or in India in 1945 or in Ireland in 1920, but I will take a modest bet that if you had conducted such a poll you would not have obtained similar results. ‘Give me liberty or give me death’ is a slogan that has resonated down the ages. ‘Give me liberty or give me £500’ does not have quite the same appeal.

Nevertheless, and perhaps surprisingly, the debate on Scottish independence seems very largely to be about economics. That is why you have asked me here tonight. I hope to give you some clues as to whether the answer is that people would be £500 better off or £500 a year worse off. As with everything economic, however, we cannot be sure, or even confident, in our predictions.

Having started with a historical perspective, I am going to continue in that vein. The 19th century was the century of the rise of large states; countries became bigger, empires were formed. Continental Europe saw the political reunification of Germany and of Italy. France, and particularly Britain, built colonial empires. The United States expanded to occupy the entire northern part of the American continent.

If nineteenth-century states tended to become bigger, in the 20th century the opposite happened. Empires progressively collapsed. That process began in the weak Turkish and Austrian empires. The process continued, and ended with the century, when the Russian empire disintegrated. The British Empire went by the wayside in the meantime.

The number of members of the United Nations at its formation was around fifty, and has today expanded to around two hundred. Some of the most successful performers in economic terms over the last century have been small states – such as Switzerland and the Scandinavian countries – which have moved from being among the poorest states in the world to among the richest.

The 19th century was a century of empires and state expansion. The 20th century saw a reversal of that trend. It’s not surprising that we see these developments reflected in the fall and rise of Scottish nationalism. In the 19th century people talked about North Britain, in the 20th century Scottish nationalism revived to the point at which nationalists control the government and are able, or perhaps obliged, to hold this referendum we are here to discuss. As an economist I look to economic explanation of historical trends and in this case, I think the explanation is largely an economic one. In the 19th century there was a widespread belief – not then without foundation – that the prosperity of a nation depended on the physical resources it commanded: land minerals and the like.

But that belief turned out to be exaggerated. By the beginning of the 20th century there were the beginnings of recognition that the price of state expansion by military means to control territory and resources might exceed the value of the territory and resources themselves. By the end of the century, an understanding of that was a commonplace of Western European and Japanese politics, even if not necessarily universally acknowledged in the United States, or Russia, or perhaps China.

And so, the part of the world of which Scotland is a peripheral part saw the sources of economic advantage in a different light. We now live in a world of relatively free trade in which small countries are able to compete effectively in global markets by specialising in narrow areas of competitive advantage. When I describe the success of these peripheral small countries in Western Europe, such as Switzerland and Scandinavia, it is on that understanding that the success of these countries is built. In Switzerland we see prosperity that is built, not primarily on financial services as some people think – they are a relatively small part of Swiss GDP – but on exports of precision engineering and speciality chemicals. The motor of the Danish economy is a group of medical industries clustered round Copenhagen.

The economies of other successful small European states are similar. A country like Iceland for example, whose principal product is fish is very poor if it is autarchic as there is a limit to the amount of fish anyone can eat. As a principal producer of fish for a European market however, a small country can be very rich. Iceland, it should be said, is also a prime example of the illusion that a successful economy can be sustained in the long run on financial services. But that is a topic for another day.

Small states in the modern world are not only viable in economic terms, but some are among the most successful in the global economy. That is, there are few economies of scale – as an economist would put it – in state size today, outside military expenditure; and armed strength is of reduced, perhaps negative, value. Arguably there were such economies in the 19th century and certainly that was believed then. But now being small is entirely consistent with very high levels of national prosperity. However, such prosperity is conditional on being an active and effective player in a global economic order. Ireland’s romantic nationalist fantasy of economic as well as political independence condemned it to fifty years of disappointing performance until EU membership symbolised and facilitated a new open economic order.

Independence is certainly a feasible option in economic terms. Is it a desirable one? Turn now to some characteristics of the Scottish economy. As an economist does, I look at Scotland in terms of economic statistics. When I compare Scotland with the UK as a whole, one begins with the observation that there doesn’t seem to be much difference. Economically, Scotland looks like the UK as a whole.

Income per head in Scotland is close to the UK average, over the last fifty years it has moved over in a range from 90% to 100%. The nadir was reached in the 1960s when that figure dipped briefly below 90%. The peak was reached in the 1990s when it approached 100% and since then has fallen back slightly. That makes Scotland the richest part of the United Kingdom outside London and South East England. The growth rate of Scotland has been slightly lower than that of the UK, but – as is obvious from the fact that average income per head has remained in line – that difference in average income is accounted for more or less entirely by this slower population growth.

Population is one significant area in which there is a difference between Scotland and the UK as a whole. Over a long period population growth has been around ½ % on average less in Scotland than in the UK. A significant part of that difference is accounted for by net emigration.

The industrial structure of Scotland is also similar to that of the UK. A myth often heard is that Scotland is much more dependent on public sector employment than the UK as a whole. There is a small amount of truth in this but we are talking about a difference of around two percentage points. As I will describe later, that difference is accounted for almost entirely by greater spending on staffing in health and education than in Britain as a whole. But Scotland also looks rather like the UK in another sense. The country has an economically dominant capital city just as the UK does. Yet it is not the country’s largest city. The special position of Glasgow has implications for the way one views the Scottish economy, but I will come back to that later.

Flickr/Scottish Government. Some rights reserved

Scotland could be an independent country and a rich country. Scotland is not in the same position as Wales or Northern Ireland, both of which would find it very difficult to operate economically without a variety of support mechanisms from the United Kingdom.

If Scotland were to vote for independence there would have to be extended and elaborate negotiations about what independence would actually mean in practice. The most important of such negotiations would be those with the remaining United Kingdom and with the European Union. The line I am going to take in relation to these negotiations is to put myself in the position of an independent chairman or moderator and therefore to try to define what some of the issues are and to decide what a reasonable basis for agreement might turn out to be.

Now, there’s a view been taken by a number of commentators on this, that all of these things are something that could be parked and dealt with after independence by negotiation between independent countries. I think to believe that is a mistake for two reasons: one is that Scottish independence would require fairly detailed legislative activity by both the Westminster parliament and the European Union and it is unlikely, in fact inconceivable, that that legislation would be passed and agreed to without there being a fair degree of consensus on specifics. The second reason is that parking issues creates uncertainty about what they are about what the resolution would be and that uncertainty inevitably creates large economic damage making it difficult to make appropriate business decisions during the period in which these issues would have to be resolved. The biggest issue on which that problem arises relates to the decision an independent Scotland would make about currency.

Now in the previous separation, which occurred in the UK, when Ireland became independent in 1921, the issue of what the currency would be was parked. After 1921, people in Ireland carried on using English pounds in exactly the same way that they had been doing before 1921. The issue arose as English pounds were issued by the Bank of England through Irish banks. It was only in 1927 that Ireland started to have its own bank notes and for a long period after that they backed these Irish notes completely with Bank of England notes. This meant the Irish note was dependant upon the English currency. It wasn’t until 1942 that Ireland established its own central bank and it wasn’t until 1979 that the fixed link between the Irish pound and the British pound was finally broken.

Well, it wouldn’t be like that in the case of an independent Scotland, because the world is now very different from the one that operated then. To see how different it could be, we should look at the case of another split which occurred in Europe in living memory; the split of Czechoslovakia. The intention there was to park the currency issue; but it emerged very quickly that it couldn’t be parked. Three weeks after the two separate countries came into being at the beginning of 1993 there was a decision to have separation between the Czech crown and the Slovak crown. That decision was kept secret for three weeks so that there could be preparations, but six weeks after the two countries became independent the Slovak crown immediately went to a discount.

And what had forced that decision in large part was that even before the two countries became separate there was a large flight of funds from the Slovak region of the country to the Czech region which gathered pace after separation. There was then a degree of chaos when the separation was announced because it was impossible simply to print bank notes in time. The result was that notes were stamped as either being Czech or being Slovak and Slovaks took their notes across the border to the Czech Republic in order to get their currency stamped as the more valuable Czech equivalent.

Czechoslovakia was a country, which had just emerged from almost 50 years of Communism. It was a country with not very sophisticated financial institutions, and yet, the effect on the operation of the financial system was so dramatic that it was impossible to function without making clear what the currency arrangements would actually be. The implications are fundamental to the independence debate because if we do not know what the post separation arrangements are going to be, we are vulnerable to the kind of instability and chaos, which Czechoslovakia experienced.

What then are the currency options between England and Scotland? There are basically three: one is to join the euro, the second is to form a monetary union with the UK and continue to use Bank of England pounds and the third is to have a separate Scottish currency. I would like to say something about each of these three options.

If Scotland were to apply for membership of the European Union, it would have to accept that the euro is its official currency. However, Scotland would initially not even qualify for membership of the Eurozone because, as we will see in a moment, it would have debt and deficit levels that would grossly violate the Maastricht criteria. In that sense, it wouldn’t be an immediate issue, but the position of a Scottish currency would be one issue that would have to be negotiated between the two.

Flickr/mebrett. Some rights reserved.

Now that leads one to a broader discussion of the economics issues between Scotland and the European Union. Most of that is straightforward; recent accession countries to have been told they have to take the Treaty as it is and one can expect that much the same would be said to Scotland. There would, however, be discussion in those areas where the United Kingdom has negotiated opt outs or other special arrangements.

It seems to me that in one’s role as chairman or moderator of these proceedings, one can point to obvious solutions for most of these issues. It would not be sensible for the European Union to insist on Scottish accession to Schengen, or to require Scotland to abandon its VAT rate. It seems to me the chances that Scotland would get a budget rebate from the European Union are about as high as those of persuading the European Union to adopt the kilt as required dress. The currency question would probably be settled by vague aspiration on the part of Scotland to join the euro at some time in such an indefinite future that it would not be relevant to any current decisions.

We can, I think, rule out the euro option, leaving us with two other options. It would be sensible, as Scottish ministers have currently proposed, for Scotland to attempt to form a monetary union with England after independence, but it would not be an easy goal to achieve.

The debate would be conditioned by recent Eurozone experience. Conventional wisdom today suggests that monetary union is only feasible if there is a very high degree of fiscal coordination leading in the direction of fiscal union, if there is a banking union, and if there is also widespread coordination of other policies. One may be certain that is the position the Bank of England and the Treasury at Westminster would take.

The question then arises whether the outcome of such a negotiation would be one consistent with reasonable aspirations for an economically independent Scotland. I am bound to say that I find it difficult to believe that would be the case because of the fundamental asymmetry between a country that is potentially 8.5 % of monetary union and a country that is 91.5 % of a monetary union. In these circumstances the rest of the UK would seek extensive fiscal oversight over the management of the Scottish economy and would be unwilling to concede analogous oversight from Scotland over the fiscal and other policies of the UK. At the very least, one would have to be prepared for the possibility that these negotiations would not succeed and if these negotiations would not succeed the principal alternative for an independent Scotland would be an independent currency.

Now if that option is on the table – and I believe it has to be if one is to talk about independence for Scotland seriously – then a separate currency will become relevant not just from the day of independence, but the day at which independence itself becomes a serious option. If there were to be a vote in Scotland for independence – indeed if it were believed to be likely that the vote in Scotland would go in favour of independence – both sophisticated individuals and businesses would start positioning themselves to ensure that they benefited from, or at least did not lose out, from the establishment of a separate currency. They would start asking what might happen to my bank account, my life insurance policy, my mortgages: is my account likely in future to be a mortgage in Scottish pounds or in English pounds? As soon as people start asking that question, you get uncertainty and instability. We have a problem in that it is very difficult to decide what the outcome of these negotiations would be and yet vital that everyone knows what it is.

My conclusion is that the perhaps inevitable, if second best, option for an independent Scotland would be an independent currency. That outcome entails costs, although one should not exaggerate these costs. If there were an independent Scottish pound it would be sensible for Scotland to peg it to the English pound, as the Irish did for so long. A more relevant and current example is the Danish krone, which has, since the euro was established been pegged against it. Danish businesses maintain accounts in krone and in euros, as the peg provides Denmark with much of the stability which a formal currency union would offer. That said, it must be acknowledged that in Denmark (and in Sweden whose currency has broadly followed the euro though with significant fluctuations) politicians and business people would like the country to join the Eurozone. It does not happen because the voters won’t agree to it.

A currency peg, formal or informal, is a realistic option for Scotland. Such a move may in fact be a necessary outcome for moving towards independence. And to repeat, this is not an issue that can be parked, but one that must be dealt with at the very beginning of negotiations.

Let me talk briefly about some other issues that will arise. Negotiation of the debt allocated to the two countries is an issue, but a relatively easy one. It’s pretty clear in my role as independent chairman that I would allocate debt to Scotland on the basis of relative incomes of the two countries or the relative populations of the two countries; there is not very much difference between the two.

The current fiscal position is that Scotland receives for the bulk of its expenditure a block grant from the UK government, which is primarily related to health and education. These are the main expenditure items which are devolved functions. The allocation to Scotland in that block grant is around 10-12% higher per head of population than the corresponding figure for the UK as a whole. In other words, there is this cross subsidy in effect from the UK to Scotland. But, perhaps not coincidentally, that cross subsidy equates roughly on average to the result of an allocation of oil revenues by reference to territorial rights in the North Sea. Scotland would have a budgetary position that was more volatile and more uncertain, but on balance neither substantially more favourable nor substantially less favourable than the existing position. Scotland would have a borrowing capacity that would be limited by a debt to GDP ratio. This would be not very different from the not very favourable debt to GDP ratio that would pertain to the UK as a whole at the time of independence.

Public expenditure in Scotland is a little more than 10% per head higher than that of the UK. This additional spending mainly goes on health and education and that expenditure in turn mainly goes on higher staffing levels. Class sizes in schools in Scotland are significantly lower than in the UK. Interestingly, that favourable pupil-teacher ratio is not reflected in higher levels of educational attainment. Indeed, since the beginning of the century educational attainment levels in standardised tests have been improving slightly in England, but have not in Scotland over the same period.

Scotland also spends more per head on health. That again goes mainly on more doctors and nurses and other ancillaries per head of population than in England. That is not reflected in better morbidity, or mortality figures in Scotland. Indeed the position on both indicators is markedly worse than that of the UK. Scotland is the worst health performer among major countries in Western Europe. That adverse outcome is partly accounted for by particularly poor outcomes in Glasgow and the west of Scotland. But poor health is a general Scottish issue and a Scottish problem.

Put bluntly, Scotland spends a lot in its public sector and it is not very clear what Scotland gets for that expenditure. As a result of the spending splurge that took place in the United Kingdom from 1999-2006, Scotland was given more money in the block grant than it could sensibly spend. In the early years of devolution, they didn’t spend it very well. Having just come from Edinburgh and being delayed yet again by the tram works, I was reminded that the inept expenditure of the first stages of devolved Scottish Government will have a permanent monument.

In the concluding part of what I say this evening, I will talk about the most important group of issues of all. What would independence mean for the performance of business in Scotland? It is on the answer to this question that the long run success or failure of the Scottish economy depends.

I described earlier the extent to which the economic performance of a small state like Scotland depends on its ability to develop competitive advantages in relatively narrow areas of specialism, which are then exploited on a global scale. I illustrated how some other countries in Western Europe have done this. I think we need to ask the question ‘what competitive advantages does Scotland have, or might Scotland have, that would enable Scottish businesses to compete as effectively as Swiss businesses, or Danish businesses, or Swedish businesses, or Finnish businesses: first within the European Union and then in a worldwide market?’ If one identifies areas in which Scotland has potential competitive advantages, we can come up with about four or five.

We might start with financial services. This is problematic because the record of Scottish financial services over the last decade has certainly been distinguished, but not in a good way. Having established over a century or two a reputation for prudence and conservatism, Scotland managed to dispel that particular reputation in a short-lived phase of folly from 2003 to 2008. Even if Scotland no longer has the position in international banking to which it once aspired, Scotland nevertheless retains quite a strong position in insurance and in asset management. The position in relation to other financial services is, I believe, recoverable. Scotland benefits from its time zone and the role of Edinburgh as Britain’s second financial centre and – as far as asset management and insurance are concerned – a reputation for conservatism and competence remains largely intact.

Scotland has a potential competitive advantage in tourism for reasons we all recognise, although we may be thinking today that it would be easier to realise that potential today if Scotland were a few degrees warmer. If one looks at the figures for tourism levels in Scotland relative to other European countries, the tourist numbers seem a good deal lower than Scotland’s potential as a tourist destination might imply. And if one is looking for the Scottish firms that will compete effectively and globally in that particular sector it is hard to identify then.

Here we come up against one of the most serious problems of Scottish business, the drain of Scottish business and Scottish headquarters out of Scotland over 20, 30, 40 years. How much of that is due to Scotland’s membership of the United Kingdom and how much would have happened anyway in a world in which London is a major financial and business centre is an open question. But certainly, Scotland has not been able to adopt policies of retaining corporate headquarters within its boundaries in ways that it might have been able to do as an independent country. There are in fact, no large tourism businesses based in Scotland. Another industry in which Scotland has a potential competitive advantage is the area of premium food and drink products. Scottish products are at the top end of the market for both these commodities. Highly prized, highly valued around the world, some firms in Scotland are active in the global marketing of food and drink products. Within these sectors, we find an iconic product. There is probably no product of any kind in global markets as clearly identified with a single country as whisky, yet the two largest producers of Scottish whisky are Diageo with a minimal headquarters actually in Scotland and Pernod Ricard: a company whose name will convey immediately to you that it is neither Scottish nor British. That being said, the arrival of Diageo and Pernod Ricard in the Scottish whisky industry has revived a sector, which was previously in decline. The takeover by Guinness of the Scottish based Distillers’ Company in 1986 put an end what is probably one of the worst and longest sagas or mismanagement in British business history.

There is a lesson there, as both whisky and banking are stories of loss of competitive advantage through management failure, and responsibility for these failures, is located in Scotland, not outside it.

Other food and drink is an area in which Scotland should have a competitive advantage, also characterised by management failure. Scotland has failed to develop new strong businesses. That observation may relate to my comments about morbidity and mortality. It is surely odd that Scotland combines some of the best food products in the European Union with the least healthy diet. Unless we address that disjunction, we may not be as successful as we should be in developing competitive advantages in food production and export.

Scotland has some competitive advantages in energy services that have been developed round the growth of North Sea oil production. Another area of specialism in Scotland is life sciences, or medical related activities. Scottish doctors have had a reputation around the world for at least two hundred years. Not only is Scotland still a major centre for medical training, but it also has a variety of spin off businesses that have developed around that particular sector. It is entirely impossible then that Scotland could develop the kind of competitive advantages in particular businesses that would enable them to compete as an independent state in global markets in the way I have described for other prosperous small states. But a great deal has to be done in order to realise this potential. And what we need to do is create a climate of enterprise and entrepreneurship within Scotland, which would lead to the growth of the kind of businesses that exploit these sorts of sectors.

The recent history of entrepreneurship in Scotland is interesting. A series of effective Scottish businesses have grown dramatically over the last twenty to thirty years. The majority have been developed by idiosyncratic individuals outside the mainstream of Scottish education and development. Our entrepreneurs are not people, as it were, who went to George Watson’s and Glasgow Academy and on to Edinburgh or Glasgow Universities. They are people like Tom Farmer, Brian Souter, Jim McColl to name three. Among more conventional middle class products of the Scottish education system, there are people who have been successful in business. But they have mostly been successful outside Scotland. One needs to ask whether it is possible to create an environment in Scotland conducive to the development and retention of such individuals in the future. That is key to whether an independent Scottish state could develop a more effective business sector.

The result of independence could be a much more vibrant economic environment. It is hard to deny that devolution has led to some revival of Scottish identity and self-confidence, and independence might do more. Independence might also be characterised by a rather unattractive mixture of conservative municipal socialism. One which did so much damage to economic progress in Scotland with crony capitalism and produced such disastrous results in other small Western European countries, such as Ireland and Iceland. There are pluses and minuses in the ways independence might influence the climate of business behaviour and it is far from evident what the balance might prove to be. But this issue is the central economic question in the independence debate.

I could have talked about many other economic issues, but I have described what I think are the principal ones. Currency and fiscal arrangements are fundamental and pressing. The issue that is central in the long run is the development of an enterprising entrepreneurial business climate within Scotland. These are the issues on which the economic debate, which runs up to the referendum should concentrate on.

Those who talk about the economic consequences of independence need to move beyond vague aspirational statements such as ‘an independent Scotland would have the powers to tackle poverty in Scotland’. That is not quite the same as identifying specific policies that would address poverty and explaining how they could be implemented either within or outside the framework of the United Kingdom.

Nor should we devote much time to arguments for independence which imply that an independent Scotland would have lots more money from some unexplained source, and would therefore be able to avoid making choices on taxation and spending and debt. Unfortunately, such choices have to be made, not only in the framework of the United Kingdom, but also in any framework other than that of cloud cuckoo land. The advantage of independence to me is not that it enables one to avoid hard choices, rather that it forces one to make them, instead of blaming others for their necessity. Independence identifies clearly where the responsibility for making them actually lies.

So how should one vote, if one’s vote is to be influenced by whether one is to be £500 better off or £500 worse off? You won’t be surprised that I am not going to answer that question. What I will say is that plus or minus £500 is about the outer limits of the economic effect that independence is likely to have on Scotland. Much of the debate, almost all in fact, is conducted around economic issues. You have asked me here tonight to talk about these economic issues, which is appropriate since that is what I think I know. But Scottish independence is not primarily an economic issue. Anyone who goes to the ballot box in 2014 believing either that they should vote ‘no’ because independence for Scotland would be likely to be an economic disaster or vote ‘yes’ because they believe it is likely to lead to an economic bonanza, has failed to review the issues sensibly. This is not, in my view as an economist, a debate which should be conducted primarily on economic issues; any more than the independence debate in the United States or India or Ireland was primarily about economic issues.

About the author

John Kay is the former director of Said Business School at the University of Oxford. He is an acclaimed author on economics and business and a regular columnist for the Financial Times since 1995. His career has spanned think tanks, consultancies, business, and investment companies.

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