An Independent Scotland Risks a Greek Tragedy

This will not be my last look at Scottish independence between now and the September 18 referendum but it will keep us going for now. I urge readers in other parts of the UK not to switch off now. It matters, and it matters rather a lot.

Independence is not all about economics but if the economics does not work it will be a pyrrhic and ultimately damaging victory for its supporters.

My focus today is on Scotland’s fiscal and financial position, not least because voters are not in my view getting the true picture. Of course this piece, along with pretty much everything else produced south of the border, will be dismissed by the nationalists. But it is accurate.

So, I have two aims. The first is to briefly set out a few basic facts on Scotland’s fiscal position. The second, more substantive aim is to introduce a rather interesting forthcoming report from Fathom Consulting, a firm which has no political axe to grind on independence, one way or the other, but which has a new take on it.

Let me begin with those fiscal facts. You may get the impression from listening to some Scottish politicians that Scotland is in a healthy fiscal position. Most nationalists have stopped claiming that Scottish taxpayers pay more into the UK Exchequer than they take out but nonetheless give the impression of rude fiscal health.

It is not true. The latest Scottish official figures, taken from Government Expenditure and Revenues Scotland (GERS), show that if calculated on the same basis as the rest of the UK, a so-called per capita basis – with oil revenues shared equally across the UK – Scotland had a budget deficit of 13.3% of gross domestic product in 2012-13, the latest year for which figures are available. That compares with 7.3% for the UK as a whole; the Scottish deficit is nearly twice as large.

The Scottish deficit, on this same basis, peaked at 16.5% in 2009-10, when the whole of the UK deficit was 11% of GDP. Edinburgh has a fiscal problem. High levels of public spending are not matched by the onshore tax base.

But surely, you will say, Scotland has North Sea oil. Yes it does, and it might be allocated 90% of it post-independence. But every reputable forecast, including the most recent from the Office for Budget Responsibility, shows a future decline in output and revenues from the North Sea. Even with 90% oil, Scotland’s budget deficit in 2012-13, 8.3% of GDP, was bigger than that for the whole of the UK. It has been bigger on that basis for the past 25 years.

It will get even larger if John Swinney, the Scottish finance secretary, follows through on his recent suggestions that an independent Scottish government would deliberately borrow more to boost public spending.

That is the backdrop, now for that Fathom Consulting report, ‘Economic consequences of independence for Scotland and the rest of the UK’, written by Florian Baier and Erik Britton, in response to requests from clients – some of them north of the border – for an assessment. I shall return on another occasion to the implications of independence for the rest of the UK.

Fathom’s report is a balanced one. It sets out the conditions under which an independent Scotland could succeed. But it also describes a scenario, one that it is in danger of following, in which an independent Scotland would be seen by investors as being as risky as Greece.

Fathom’s sovereign fragility index shows that the government bonds of an independent Scotland without a geographic (90%) oil share would be so far into junk status as to be beyond Greece. Those very large (13.3%) budget deficits on a per capita basis would scare investors.

Even if Scotland gets a geographic share of oil, however, it would not be out of the fiscal woods. Fathom estimates that it would still be as fragile as Greece, not because its budget deficits are a bit larger than the whole UK but because it would carry too much banking risk.

As things stand, Scotland’s banking assets – in practice the potential liabilities of an independent Scottish government in the event of independence – are a staggering 1,100% of GDP. Scotland has a potential banking liability of Icelandic proportions, and much bigger than those (700% of GDP) which almost bankrupted the Irish economy.

To be viable, Scotland has to get rid of its banks, or at least their domicile, and keep a much smaller level of banking operations and assets. Some would say this process will happen anyway, or is happening; RBS’s Gogarburn headquarters on the outskirts of Edinburgh, otherwise known as Fred’s folly, as in Goodwin, is said to be a shadow of its former self in terms of the numbers employed there. But the nationalist position appears to be that they can hold on to their banks, and the rest of the financial services industry. Even if that could be achieved, it would be a fatal error.

A Scotland with geographic oil and a greatly shrunken banking sector would still not be financially viable, according to Fathom. The other ingredient is an independent currency. Having been rebuffed on monetary union by the three main parties in Westminster, Alex Salmond, the Scottish first minister, insists an independent Scotland will continue to use the pound. That would be the worst of all worlds.

The case for an independent currency is simple. Though North Sea oil is diminishing it would still be disproportionately important for an independent Scotland. When oil prices are strong, that would boost the Scottish economy, and vice versa when they are weak. Stuck in an unofficial currency zone with the rest of the UK, or an official one at some later date as a member of the euro, Scotland would lack the currency flexibility needed to respond to these shifts. It needs its own independently floating currency, a petrocurrency.

Could an independent Scotland work? Yes, if it allows the banks to leave, establishes an independent currency and takes tough but gradual fiscal action – spending cuts and tax hikes – to make its public finances healthy. Unfortunately, none of these three policies appears to be on the Scottish government’s agenda.

That could be very bad news. According to Fathom: “Any other settlement … could make it impossible for Scotland to borrow, forcing the government into a severe tightening of fiscal policy and Scotland into recession. Scotland would face a situation worse than the one that has been facing Greece for the last few years.”

I don’t know what effect that conclusion will have on floating independence voters but it would certainly scare me.

This piece is cross-posted from with permission.