Speech given at the Caledonian Club in London on September the 3rd

Reducing the gap between supporters of keeping Scotland in the UK and those favoring independence reflects both the passion around this issue, but also the limited period of time before the deadline of the 18 September. The YES progresses and the poll published this morning gives it at 47% against 53% for the NO (recent polls are here). Suddenly, the gap that seemed unbridgeable is dramatically narrowing. We need to keep in mind the 2005 referendum in France on the European constitution. The YES pranced for many weeks but eventually lost. The perception we can have of the Scottish referendum may be on the same dynamic. The impact of the narrowing of the gap can be perceived through greater nervousness seen in some segments of the financial markets. The pound was weakened and its volatility has increased.

Recent episodes on the separation of this type are few in developed countries. Two recent experiences are interesting to tell.

The first is the one that led to the creation of the Czech Republic and of Slovakia at the end of 1992, Vaclav Klaus and Vladimir Meciar each topped in regions that will become the Czech Republic and Slovakia in a general election. They decided together to break even if Czechoslovakian were largely in favor of unity. Finally the separation occurred because the history was too different in the two countries due to different attachments. The Czech Republic was more depending on Germany and Austria while Slovakia was more Hungarian. Their history has been temporary common but over time it was not. Even their languages ​​ were close but not identical. What to take away from this episode is that the lack of shared history was a key factor in facilitating the separation. In the case of Scotland and the UK, the story is near and generally common (307 years). The case of Czechoslovakia was probably facilitated by the period in which it took place. The fall of the Berlin Wall in November 1989, required rethinking the institutions and the way people lived in Central European countries. The separation is thus enshrined in the confusion and uncertainty that existed at the time. Note that if the distribution of institutions between the two countries took time, the question of the currency, essential for Scotland, was quickly resolved. A currency union was established between the two countries. It only lasted a month.

The other example is that of Quebec. In 1980 and 1995 a referendum on independence from Canada was organized. During the two consultations, the answer was negative. What appears is that it is not a lack of patriotism or nationalism that penalized Quebec. Quebec residents had nothing to envy to Scots on this. The reason for the NO relied on economic issues. Majority voters feared that independence would not be able to create conditions for a robust economic trend. On this aspect the parallel vis-à-vis Scotland is interesting because it is a key issue. They knew what they had, but not what they will have.

The situation in Quebec is probably the one that comes closest to what is perceptible today in Scotland. The challenge is that of economic dynamics.

Before addressing this question directly, have in mind the immediate impact of a yes to independence:

• The first is that Scotland will become an oil exporter, while the rest of the UK will become oil importer. Indeed most of the oil fields of the North Sea are in Scotland. The UK deficit would rise so significantly. We cannot exclude that the economic cycle of Scotland and of the rest of the UK dissociate. So far, economic profiles of the two entities were very close and usually identical at the turning points of the cycle. The change in the sharing of oil revenues can have a strong and lasting impact on each profile.
• Scotland should buy back its share of the UK debt. Depending on the measure: PSND (Public Sector Net Debt) which is the measure of the British Treasury or under the Maastricht Treaty and whether the partition is effected according to the share of population or of GDP, the amount of debt repurchase would be between 133 and 180 billion sterling in 2016-17 (when the effective independence will take place after the period of negotiations). Following the GDP projections for this period it will represent between 75 and 120% of Scottish GDP (NIESR figures in “Scotland’s Currency Options” Angus Armstrong and Monique Ebelle DP # 415)
• The Bank of England will not have authority on Scotland
• The fourth element is that membership and representation that the UK can have in international bodies will remain at the rest of the UK. Scotland will have to build its own institutions and network. This is typically how situations are managed in the case of separation (eg France and Algeria after the 1962)

We just saw these four elements that change is already spectacular. They pose the questions to have bases on independent Scotland.

In general, the scenario that you can have is determined by the combination of 6 indicators. Their trajectories will determine the profile of the Scottish business cycle. The six indicators are the monetary system, productivity, population, oil price, public finance and the relationship with the EU and the Euro Zone.
Each of these variables can have a highly independent momentum from other profile’s variables. This is also why the determination of the actual profile of Scotland is difficult to define ex ante. Scenarios discussed during the campaign consider specific trajectories, but what interests us here is the path that will depend on these six trajectories.

The key element is the monetary system. An independent Scotland will have to choose a monetary system. Several options are available.

The first choice, the one that was recommended by the Scottish Government is making a monetary union with the rest of the United Kingdom and with the Bank of England as the central bank. This would result in maintaining the current system. But the Bank of England monetary policy committee would manage the situation without taking into account the specificity of Scotland. This means that if the business cycles between the rest of the UK and Scotland is not in phase, Scotland will not have the monetary tool to correct its own imbalances. The adjustment will systematically go through fiscal policy.
In addition, the issue of financial stability is posed. In a crisis in Scotland, what would be the behavior of the Bank of England? Scottish financial institutions overseen by the Bank of England will qualify for liquidity-providing by usual channels, but that would happen in the event of a systemic crisis in Scotland? The question is then asked to acceptance by non-Scottish UK of such an intervention by the central bank which is likely to have a specific cost to the British taxpayer.
There is another issue: fiscal policy will be a key element in the management of the Scottish question. The economic policy balances will be at risk: A centralized monetary union and a decentralized fiscal policy is a major risk for Scotland. The lack of fiscal integration has had a negative impact on the Euro zone. In this case, it is the country that suffered the crisis that adjusting itself with a strong risk of a recession (this was the case of Spain and Portugal recently). In an integrated economy, the crisis is supported collectively (the case of the United States for example). In other words, in the case of a crisis in Scotland, the government would have a single instrument to manage the business cycle with the risk to amplify the negative shock. The possibility of a currency adjustment in such a situation would have been desirable, but the fixed link with sterling prevents any adjustment.
This solution would be viable only if the cycles of the two economies remain synchronized and that there is no asymmetric shock. Nothing can spontaneously ensure such a scenario. It would, of course need the consent of British authorities. The answer is rather negative today especially from the Bank of England.

The second case, which is the one of sterlingisation, would be trickier. Scotland would use the pound sterling as the reference currency but without a central bank. The state of the financial system that could easily refinance at the Bank of England if monetary union could no longer do that and any intervention in a crisis is excluded. The link with sterling prevents any monetary adjustment and financial crises Scotland should implement its adjustment only via fiscal policy. These situations can be viable if there is a deep synchronization of the business cycle. But with Scotland becoming oil exporter, such an occurrence is unlikely. Furthermore, as was found in Latin America during the dollarization of a number of countries, prices may be too high relative to the local standard of living, creating a permanent dissatisfaction. Scotland would become very dependent on the conditions of the rest of the UK. The risks are even greater because Scotland will not have the hand on its immediate prospects. Any shift in market conditions for the rest of the UK would be harmful for her. Where would independence be? The risk of instability is strong.

The third option is the creation of a Scottish currency. This would require the establishment of a central bank and the acquisition of credibility in the management of monetary policy. The creation of a new currency would necessarily lead to, at least initially, high volatility as the pricing of the Scottish currency would not be easy. Past experiences have shown that there could be high volatility and that convergence to a stable parity is always long to emerge. This was the case of currencies in Central Europe; this was also the case for the European Monetary System (EMS). Parities that were set in March 1979 at the inception of the EMS were sometimes dramatically adjusted in the early 80s. It’s a long and expensive process because to gain credibility, monetary policy has to be very careful. Management of the economy would mainly be through fiscal policy. This could be complicated to implement as a balanced budget is not currently observed and because after the separation, the public debt will be very high as a percentage of GDP (see above). The risk is first to devalue, then to import inflation and having to tighten fiscal and monetary policies to stabilize the trajectory of the economy. In the short-term it may produce significant turbulence.

The last possibility is the desire to join the Euro-zone. This step follows the previous one as a prerequisite is to have an independent central bank. Scotland would then set up a new currency but have public finances trajectories consistent with Maastricht Treaty criteria on deficit and debt. Scotland would also have to have a stable parity for the new currency. Public debt according to the Maastricht depending on calculation goes from 86 to 120% of GDP and the effort required considerable. The quoted paper of the NIESR said that with GDP growth of 2%, inflation of 2% and an estimated 4.8% interest rate, it would take 10 years to converge towards the 60% ​​threshold as the primary fiscal balance (excluding interest payments on debt) will have to increase from -2.1% in 2012 to 3.1% 10 years later. The fiscal effort would be considerable.

Given these four assumptions on the currency system, the monetary path will be complex. It can give the feeling that there is still a strong dependency on the rest of UK and specifically to the Bank of England. It can also be a situation where fiscal austerity becomes the rule in order to improve credibility of the new system where the deficit is large and the public debt important.
The most satisfactory medium and long-term choice would probably be the creation of a new currency but then result in a rather chaotic period at the beginning, the time to find and then to converge to a stable path. In that case, Scotland would have a fiscal and a monetary policy.

The choice that will have to be made on monetary matters is fundamental because it will determine the type of expectations that Scots but also foreign investors will have. If the system is not seen as credible, it would cause a sharp increase in volatility and the risk premium on Scottish assets. Thus in the case of a sterlingisation, we cannot exclude that expectations of failure may appear. In this case, the situation could be weakened from the start.

5 other themes are important but somehow, they do not depend on choice. They reflect historical dynamics but whose future profile could be hazardous.

The first element is productivity. One of the goals of independence must be to gain growth autonomy. The economic system must be able to generate significant productivity gains in order to create a dynamic employment and income and to converge to a virtuous momentum. In the project of independence, lower corporate tax rate is the key element to generate this dynamic. In the same project, productivity gains and caused enable improved revenue and greater ability to improve the public finances balance.
The problem is that data on productivity suggest a weakness compared to the average UK. Calculations (see the work of Richard Harris and John Moffat here) indicate that productivity (TFP: Total Factor Productivity) is 11% lower than the UK average and even 22% compared to the most dynamic regions. Scotland did not have a specific appeal encouraging businesses to locate in this place and to generate strong growth momentum.
The lower tax rates on businesses can create an incentive but can this be sufficient as long as the currency issue, mentioned above, is not resolved? Who is going to invest if there is a lot of uncertainty in the financial system, while the value of the currency is not fixed?

The second factor is the aging of the population. Projections indicate a slight downward trend in the labor force (16-59 years), but a rapidly aging population (for more than 75 years). This is shown by the graph below. This raises the issue of income distribution. As the population ages, income distribution and public health spending are moving to elders. This can create a reduced incentive to work for the working age population. If the independent Scottish government wants to boost production and productivity of Scotland must be able to change the regime and attract more people. But there also will require that the currency issue is resolved. Any doubt on this point would penalize the Scottish economy.
The third point is critical because it is oil. The desired Scottish model might look like the model of Irish or Norwegian growth. In one model or the other, there is an exogenous income stream. Because of international companies based in Ireland that have an activity in the whole of Europe and the revenues thereof are repatriated to Ireland for tax reasons. In Norway, these external revenues are related to oil exploration. For Scotland, the flow of oil would come from the North Sea since the distribution of the well will be very favorable to her.
The oil should be a dynamic source of activity and resources to the new Scotland. However, the major issue is the sustainability of production. The graph below illustrates changes in the production in the North Sea. It is observed that the offshore production was 2.5 million barrels / day in the late 90s but in 2014 it was less than 1 million. Projections do not allow let expect a rapid reversal of the trend. The wells are exhausted and if production techniques are improving it will extend the duration of the exploration but it will not create an autonomous dynamic as has been the case in the past.
This weakens the independent Scotland for several reasons.
The first is that it will not be a very important source of income, not as important as expected and the risk of further reduction is quite important in the coming years. The second point is that the Scottish budget dynamics is strongly influenced by the oil revenues’ profile.

The fifth point to be raised is public finance. The budget of Scotland is highly unbalanced. The total budget balance is negative 6% in 2012/2013 but excluding oil revenue is clearly negative as shown in the chart below.
We then have several elements to mention
1 – The profile of future oil revenues will largely condition the room for maneuver of the Scottish fiscal policy.
If these revenues are slowly fading then public finances requires:
2 – That income related to operating activities increased rapidly to compensate. This means significant efforts on productivity but also on the composition of the labor force. This is a strong assumption as I said above. But we saw that it would take time for the implementation of the policy combining productivity and labor force will be slow to bear fruit and that the choices made will be very dependent on the choice of the currency system.
3 – In addition, the fiscal policy will be conditioned by the choice of the monetary system in particular because we saw the need to gain credibility went with a rather restrictive fiscal policy.
4 – The choices made and the level of public debt resulting from the separation of Scotland from the rest of the UK is going to determine the profile of the Scottish debt. The initial level of debt is high, as mentioned above, but its profile will be conditioned by the revenue that could be more uncertain on oil prices side, by the need for productivity gains and by expenses that will affect the budget because of the aging population.
In other words, the aging costs are certain, oil revenues and the benefits of productivity gains are more random. The risk is high to see the rapid increase of the public debt. This will reinforce the need to adopt a restrictive fiscal policy which will adversely affect the immediate economic environment

The last element to consider is joining the EU and ultimately the Euro zone. This membership must be made unanimously. It is not certain that Spain will sign spontaneously due to uncertainties in Catalonia. This entry could be a stabilizer because it implies the implementation of strong institutional with a clearly defined framework. If there is a risk of not being a member of the EU the situation will become more difficult to understand as it will become more uncertain. A major challenge is to effectively facilitate investment flows and population to Scotland.

Conclusion
The result of the referendum of September 18 remains uncertain but if the result is in favor of independence, the major choice will be that of the currency. It will determine and eventually stabilize expectations. If this choice is not clear then there will be more uncertainty generating risk premiums on Scottish assets. This would be detrimental to Scotland even before independence was actually takes place in 2016.
The Scottish Government wants the monetary union but would lose any possibility of currency adjustment. That would be detrimental in a crisis because after independence, budgetary dynamics would no longer be integrated. But even in this case, negotiations will be tough to define the part of the public debt up to Scotland and as well as oil wells. The story does not end on September 18 evening.
If the case of a win for the NO, the Quebec example suggests that it does not bury the idea of independence, especially when in 2017 the British government is setting up a referendum on UK membership in the European Union. Cards could again be redistributed.