The Growth Commission’s recipe for recession

The Growth Commission’s recipe for recession

by Robert Kilgour
article from Thursday 31, May, 2018

THE SNP’S ‘Growth Commission’ – designed to recast the economic case for breaking up the UK – proposes measures that would restrict growth and damage business and jobs. As Chairman of Scottish-Business.UKit is clear to me the new plans for independence would pile costs on business and restrict trade with our main trading partners in the rest of the UK.

These include a period of crippling uncertainty for businesses as the SNP plans to retain the use of sterling without controlling the currency, higher borrowing costs once the pound sterling is finally abandoned and higher taxes (and/or spending cuts) from having to close the spending deficit that an independent Scotland would immediately have.

As before, the case for independence uses selective data and logical contortions to come up with imaginary benefits. For example, there is no real correlation between the size of a state and its economic performance. A country’s success is based on its institutions and the policies its follows.

Most Scots would question the honesty of any study that tried to claim simultaneously that Brexit is economically damaging but Scottish independence somehow isn’t.

The powers are already there if politicians have the desire and focus to use them. It’s just a question of priorities – arguing about independence is one thing, helping real people and real businesses is quite another. Here is how I see the key points:

Currency

  • The Growth Commissions’ idea that we should try to keep Sterling for several years before launching a new currency offers the worst of both worlds.
  • Continuing to use Sterling from outside the UK would mean the Bank of England would still set our monetary policy but with no requirement to take Scottish conditions into account.
  • The new arrangements would present serious challenges to Scotland’s financial sector, which is a major sources of revenue, skilled employment and tax revenues. Scotland’s banks rely on the Bank of England to act as a lender of last resort which guarantees their liabilities and long term solvency. Without a fully functioning central bank we would have no capacity to underwrite Scottish banks, which would have to move their domicile south of the border to retain protection from the UK regulatory and financial regime – something the report comes close to admitting [see 3.219].
  • Like the banks, Scotland major fund managers and pension companies have the great majority (circa 90%) of their customers in other parts of the UK. Financial conduct and products such as investment, pensions, insurance and savings are regulated and guaranteed by the UK’s Financial Conduct Authority and Bank of England. Post-independence, these businesses would require continued FCA and BoE supervision and would most likely need to move headquarters and other leadership functions into their jurisdiction.
  • A new currency is the logical outcome of Scottish Independence, so the Growth Commission at least is honest in this regard (even if it envisages the damaging period in the no-man’s land of ‘sterlingisation’). However a new currency presents major problems to Scottish business and the country as a whole.
  • The new currency would come under immediate pressure, leading to depreciation against Sterling and other currencies, inflation and higher a higher cost of borrowing. There are three main reasons for this.
  • Scotland’s higher fiscal deficit (on which more below) would mean that Scotland would need to borrow more, increasing the cost of borrowing in international markets, leading to higher interest rates at home;
  • Reliant on a much smaller tax base than the Bank of England, the new Scottish central bank would have less capacity to underwrite Scottish debt, leading to a higher risk premium on that debt (and therefore higher rates);
  • Unlike the Bank of England, the new Scottish currency and central bank would have no track record and would present a riskier prospect for international lenders, again leading to higher interest rates and a higher cost of debt. It would take many years to gain credibility in international markets and this would only be achieved if the Scottish Government substantially reduced the fiscal deficit[1]. Again, these problems are alluded to in the report, but with no realistic measures to address them apart from a delay in setting up a new currency.
  • These pressures would most likely lead to higher mortgage rates for householders and higher borrowing costs for business. Currency depreciation would make it more expensive to import goods through the supply chain, leading to inflationary pressures.
  • Currency fluctuations with Scotland’s main trading market – the rest of the UK – would add costs and uncertainty to any business sourcing and supplying goods or services across the new border. This would act as an impediment to trade and hurt employment. Currency transaction costsreflect both the risk and uncertainty of future exchange rates and the actual charges incurred from the process of dealing in two separate denominations[2].
  • A new Scottish central bank would not wholly solve the ‘lender of last resort’ problem because it would not have the same capacity to underwrite Scottish banks.
  • Nor would it solve the problem of other financial institutions changing their domicile to seek continued FCA and BoE supervision.
  • A major question mark exists over Scotland’s approach to paying existing liabilities such as pensions, our share of sovereign debt and on-going contracts. The report assumes that Scotland would not inherit liabilities but, bizarrely, would nonetheless pay an annual ‘solidarity payment’ towards the cost of servicing them. The truth is that it would have to be negotiated what currency these debts would be denominated in. If liabilities were in Sterling then their cost to the Scottish taxpayer would rise as the new Scottish currency depreciated. If debts were paid in the new currency, that would represent a fall in the value of the debt, affecting hundreds of thousands of Scottish pensioners as well as institutional lenders.
  • If Scotland left the UK and joined the EU it may at some stage be required to adopt the euro. This would reduce transaction costs on EU trade but would risk locking Scotland into an inappropriate monetary regime that did not recognise Scotland’s distinct business cycle and applied the wrong interest rates at the wrong times. It is difficult to justify leaving an optimal currency area with our biggest trading partner – Sterling and the UK – for a currency area that is clearly problematic for economies outside the euro core. The many issues around Scotland’s relationship with the EU are not addressed in the report.

 

Tax and Spend

  • The Growth Commission admits that Scotland faces a much greater fiscal deficit under independence that would need to be tackled over time. However the authors underestimate the extent of this deficit and underplay the impacts on business, jobs and the country as a whole.
  • The bulk of the deficit is caused by much higher public spending currently in Scotland than in the rest of the UK. This is not matched by tax revenues (which are currently, per capita, somewhat lower the rest of the UK). Overall this element adds around £9.5bn to Scotland’s deficit. A newly independent Scotland would have one of the worst deficits (8.3%) in the OECD.
  • The deficit is not closed by oil revenues (as is admitted by the Growth Commission). At times in the past oil revenues have matched or exceeded the public spending premium that Scotland enjoys. While there may be new oil discoveries in the future, and the price of oil may rise, forecasts are for a downward trend overall. Oil revenues are not a stable or predictable way to close the fiscal gap that we can rely on going forward.
  • Meanwhile the Growth Commission does not take into account several items that would add to the fiscal deficit. For example, the set up costs of separate Scottish Government departments have been estimated by the SNP themselves as much higher than the £415m stated in the report. Scottish energy producers currently enjoy UK wide energy subsidies that are largely paid for by UK consumers that would disappear on independence. These additional items[3] would outweigh any savings from defence or foreign aid cuts.
  • Instead, the fiscal deficit will have to made up, at least in the short and medium term, through a combination of higher taxes, lower public spending and higher public borrowing (with the consequences of this latter addressed above). The Report admits that spending would have to grow at a lower rate than Scotland’s economic growth rate as a whole, but does not spell out what this means in practice.
  • High taxes would be paid either directly or indirectly (through higher taxes on employee salaries) by business. This would add to business costs, leading to significant job losses[4].
  • Lower public spending could affect business and jobs by reduced investment in transport infrastructure, education, skills and other key public services.
  • Many engineering businesses in Scotland are partially reliant on UK defence procurement in Scotland. The UK has the world’s third largest defence budget and Scots forms would cease to benefit from this after independence. Some defence firms that also have a civil engineering arm in Scotland and may relocate or direct future investment in both arms closer to their new markets away from Scotland.

 

Barriers to trade

  • Scotland’s biggest trading partner by far is the rest of the United Kingdom. We trade four times more with England, Wales and Northern Ireland than we do with the rest of the EU. Any barriers to trade erected between us and our main market would have a disproportionate effect on Scottish business.
  • It may be that tariffs and non-tariff barriers are erected between the UK and the EU after Brexit. If an independent Scotland subsequently left the UK single market for the EU (the stated position of the SNP), any such barriers would need to arise on the Anglo-Scottish border. In effect, any Brexit costs would be quadrupled by leaving the UK
  • The Growth Commission suggests that higher migration would be the solution to Scotland’s growth problem and bridging the fiscal deficit in the long term. But while business does need access to high quality labour from abroad, this is best achieved in a UK context. There is no evidence that renewed access to the EU single market will solve Scotland’s population problems – it didn’t before Brexit. The report suggests tax breaks for migrants (penalising further those who already live here) but these would be outweighed by the higher taxes overall needed to plug the deficit.  And any significant divergence on migration policy from the rest of the UK risks further barriers to cross border business and even, as a worst case,  a possible hard border with immigration checks on entering Northumberland and Cumbria[5].
  • A separate Scotland could lead to divergence in regulatory standards in all sectors of industry, including agriculture, chemicals, food and drink, services, manufactured goods, packaging, medicines and IT, adding cost to any business that operates on both sides of the border and would then have to implement two sets of regulations.

SBUK applauds the greater honesty on show in the Growth Commission and its authors’ readiness to accept the clear challenges posed to the economy and business by independence. It also agrees with some of the measures suggested such as more investment in infrastructure. But the report is struggling to find solutions to a set of problems that currently do not exist. The authors would have done much better to spend their undoubted intellectual energies finding answers to Scotland’s problems within a framework that they admit is far less problematic in the first place – staying in the United Kingdom and retaining all benefits that this provides. It just begs the question – why change in the first place?

The powers that be

Most of the policy levers that affect business and economic growth are already devolved to the Scottish Parliament. Instead of arguing about the constitution, we suggest Scotland’s politicians should concentrate on using the powers they have to improve growth. There are enough to keep 129 Holyrood politicians very busy indeed for at least a generation, even if they focus all their attention on them. Here are just a few devolved powers that affect business and growth to get them started:

Airports;

Business rates;

Commercial and property law;

Council tax;

Criminal justice;

Economic development;

Education;

Health policy;

Higher education;

Housing;

Income tax;

Island ferries;

Land use planning;

Overall level of tax and spend;

Regional development;

Roads infrastructure;

Scottish Futures Trust;

Skills policy;

Social care;

Tourism;

Trade promotion;

Water industry and regulation;

Welfare-to-work;

Wifi.

Notes to the commentary:

[1] At the time of the Independence referendum in 2014, the National Institute of Economic and Social Research (NIESR) estimated that “Scotland would pay between 0.72 and 1.65 percentage points more than the UK to borrow at a maturity of ten years.” Based on this, consultancy Europe Economics estimated additional annual financing costs of £250m, assuming higher rates were only payable on future debt (What Costs would an independent Scotland bear in its first year, Europe Economics 2016).

[2] A 2013 study by Europe Economics, Three EU-Related Impacts of Scotland Leaving the UK estimated a total of £415m transaction and trade related costs in year 1 (2015 values).

[3] The 2016 report by Europe Economics What Costs would an independent Scotland bear in its first year estimated total government set-up costs of £1bn (based on the SNP’s own estimate of £200m to set up a separate Scottish social security department) and the loss of energy subsidies at £510m. If Scotland re-joined the EU it would be a net contributor without enjoying the UK’s current rebate. Scotland share of the UK’s gross contribution in 2017 was c£1.8bn, according to the ONS. UK defence spending was c.£36bn in 2017, implying that even if Scotland cut defence spending by half it would save just c. £1.6bn. The SNP plans to maintain international development spending at current levels (0.7% of GDP).

[4] Using the Scottish Government’s economic models of the economy, the campaign group Scotland in Union estimated in 2016 that a mix of £10.5bn split between tax increases and speeding cuts would result in a loss of output of 3% and c 125,000 job losses across the economy (5% of the workforce).

[5] Estimated cost of divergent visa rules, migration policies and border costs have been put at c£100m (see Europe Economics, Three EU-Related Impacts of Scotland Leaving the UK, 2013).

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