Scottish independence: the costs of borrowing and of transition
- 18 September 2013
- From the section Scotland business
A year out from the independence referendum, Donald Rumsfeld comes to mind.
The US Defence Secretary who rained missiles down on Iraq ten years ago is also, more fondly, remembered for observing the future carries known knowns, known unknowns and unknown unknowns.
The independence referendum features lots of known unknowns. In some we know the issues, and can guess at their scale. In some, clever people can do the algebra and provide us with estimates.
This week, a conference at a nice hotel just outside Edinburgh, organised by the Economic and Social Research Council, will take a look at some international lessons for the economics of independence.
There will be some observations about known unknowns which matter rather a lot. Here are two of them: the cost of borrowing, and the cost of transition.
The price of Scotland's debt
So, first: Scotland would face a large debt transfer, and an ongoing deficit that needs financed. What would that cost?
Those backing a 'yes' vote point out that Britain's cost of borrowing isn't looking so rosy since it lost its triple-A credit rating. With the help of Scotland's energy resource, they ask: why wouldn't Scotland be similarly rated?
They may not much like the answer from the National Institute of Economic and Social Research (NIESR). It's not a household name, but it's very reputable in its field. And it does some algebra, too.
It's taken a look at the implications of Scotland being in a currency union with the rest of the United Kingdom, as the SNP proposes.
Scotland would start by inheriting a share of UK debt, which has been ballooning over the past five years. The good news for an independent Scotland is that the NIESR thinks its debt could, at 86% of national income, be significantly lower than the 101% calculated for the rest of the UK.
Not so good is the higher borrowing cost to service that debt. The research suggests an independent Scotland would face interest rate costs of between 0.72% and 1.65% above the UK borrowing costs for 10 year debt. Between 2000 and last year, the average bond yield for 10-year Treasury bonds has been 4.1%, though it's less than half of that now.
One factor is that Scotland would have no track record of servicing debt. But this analysis puts the rate higher because of less liquidity in the bond market for smaller countries' debt. That is, if it's less easy to find a buyer when you want to sell, there's a higher risk in holding the bonds.
To prove to the bond markets that Holyrood's running a tight ship and can afford to repay debts, it would need to get its debt down, and do so rather more urgently than the Treasury in London.
To get from the current and rising UK debt levels (passed on to a newly independent Scotland) to the 60% level required of EU members under the Maastricht Treaty, NIESR says Holyrood would have to run a surplus of 3.1% annually for the next ten years.
However, its average deficit has been around 2.3% (including its geographic share of oil and gas taxation) over that same period of 2000 to 2012.
The gap between that average deficit of the past and the average surplus in the next decade suggests a 'fiscal tightening' of 5.4%. That is, you either cut spending by 5.4%, or you raise taxes, or you do a bit of both.
NIESR points out that would still leave Scotland vulnerable to a drop in the oil price or another recession, knocking its fiscal plans off course (as is the UK at present, of course). In the unique circumstances in which Scotland would find itself, the think tank has come up with an interesting, if provocative, suggestion - Scotland could trade its future oil revenue to pay off the UK's debt.
With some understatement, it is concluded: "There may be significant political limitations to this possibility."
Oil for debt
And so, it's with that background that NIESR is heading in the same direction as others who have considered Scotland's future currency options, including many in favour of independence who don't take the SNP whip - that of Scotland having its own currency.
It's argued that that would look a lot more like real independence. It gives the levers of monetary power to people in Scotland, including the ability to devalue and respond to changes that oil prices can mean for the relative position of Scotland and the rest of the UK.
But what a new currency also brings is uncertainty about the transition, and that's a hard sell to voters a year from now.
The price of change
So, to the second question: even without changing currency, what might the costs of transition be? This is a big part of the economic debate about independence.
It's highlighted by the pro-union side, emphasising the costs, and refusing to reduce them by negotiating in advance to reduce uncertainties. Nor is it willing to talk much about common interests if the UK splits.
Meanwhile, the cost of transition is played down by the pro-independence side. While it gears up for talks on currency, debt, resources, defence, splitting or sharing many other assets, shared regulation, international obligations and so on, the Scottish government reckons that negotiations will be "smooth and co-operative".
For this week's conference, Robert Young of the University of Western Ontario has applied his expertise in Quebec's efforts to secede from Canada.
He doesn't deal in algebra, but in game theory; assessing how the bluff and threat of the prisoner's dilemma or a game of chicken would deliver different results.
He points out that the economic case for independence is whether Scotland can achieve better performance than it has. Once a transition has settled down, that would be down to degree of continuing integration with the UK and the EU, inflows of foreign investment, labour productivity, innovation, and so on.
But the cost of transition comes before that, and if it works badly, it can outweigh any benefits from those other factors in later years.
By international comparison, Young points out that Scotland starts with the advantage of having secured agreement from London on the validity of its claim to sovereignty. That's a long way from agreeing to whatever Scotland's negotiators want, but at least it's the starting point for being able to jaw-jaw.
And it's pointed out that the negotiation of deals with the former capital can have the benefit of bringing people in the new nation together in common cause.
But that one benefit of transition is set against quite a range of costs. One is the transaction cost: the resources devoted to disentangling two new states and of setting up new institutions.
"No advanced industrial capitalist state has ever undergone such a break-up, but transaction costs could be very large," writes Professor Young.
One Canadian economist is quoted as saying the "institutional restructuring" required for Quebec to secede - in government terms and including others, such as business - could be more than 1% of GDP, spread over several years. In Scotland's case, that's more than £1bn.
There are then fiscal costs. These might be the least of Scotland's challenges, if the current estimates are any guide. Scotland contributes quite close to the amount it gains back from the Treasury. In recent years, there haven't been large transfers in or out of Scotland.
And third, there are the costs of uncertainty. That takes us back to the additional cost of borrowing outlined by the NIESR, on which Professor Young underlines the difficulty of estimating figures for Quebec.
Some costs, we're told, are fixed, such as setting up new institutions. But many vary, and depend on the behaviour of the two sides following a 'yes' vote.
And that's why this will remain one of the bigger 'known unknowns'.