George Kerevan: Scottish free state may be worth buying into

Oil revenues could smooth the way for Scotland to become independent and make sterling work for us

BOOM! Bang! Crash! Salvoes of academic shells are whooshing overhead after last week’s column on North Sea oil revenues and my prediction of a booming Scottish economy post-independence. I’m under intellectual bombardment by economists John McLaren and Brian Ashcroft – both of whom are, without letting it interfere with their professionalism, safely in the unionist camp.

Meanwhile, SNP finance secretary John Swinney has returned to the debate on economic policy after independence, in an interview in yesterday’s Scotsman. He affirms he would keep the pound sterling and negotiate a deal with the rest of the UK (or RUK) for the Bank of England to act as lender of last resort to Scottish banks in the event of a liquidity crisis. In return, Scotland would maintain “fiscal discipline” so as not to rock the sterling boat. Feasible or not?

In fact, this is exactly the situation that prevailed for the generation after the creation of the Irish Free State in 1922, when the newly independent 26 counties went on using sterling for convenience. Dublin’s banks continued to keep their reserves in London and two even retained head offices in the city. My old mate Michael Kelly takes an absurdly Manichaean view of independence, claiming grumpy RUK politicians would refuse any such monetary accommodation with Scotland. Yet Edinburgh’s velvet divorce with RUK hardly compares with the bloody conflict that led to the Irish Free State.

For anoraks, the Irish issued their own bank notes internally but backed these one for one with sterling reserves, thus maintaining a fixed exchange rate. People could swap Irish notes for pounds on demand at the Bank of England. The Irish monetary authorities invested their large sterling reserves – known as seignorage – making a tidy income for the Dublin exchequer, equivalent to a substantial 0.37 per cent of GDP. Holyrood would make a similar gain, helping with its budget.

Sticking with sterling would lockstep Scottish and RUK interest rates. Irish experience gives Swinney comfort in this regard. If Scotland left the sterling area immediately, the financial markets would worry about exchange rate volatility. Lenders might demand higher interest rates from Edinburgh to offset perceived capital losses from their Scottish holdings. Maintaining the link with sterling pro tem might (as it did in Ireland) pacify the markets and keep rates lower than otherwise.

Besides, there are ways of cheapening the supply of capital to Scotland, even in a monetary union. The most obvious is to create a state-owned infrastructure bank like the German KFW. Within a decade, the Scottish monetary authorities would also have built up large sterling and foreign currency reserves that would allow give them the capital to start discounting some bills for the Scottish Government and banking sector. That lending would lower high street interest rates compared with RUK, as Ireland was able to do after the 1950s.

The key issue Mr Swinney raises is not the monetary mechanics of sharing a currency – for which there is copious precedent. Rather it is the fiscal discipline this would impose. An independent Scottish Government, without a central bank as lender of last resort, would be forced to balance its books over the business cycle or risk penal interest rates. How can John Swinney be fiscally conservative, yet cut business taxes (for growth)?

Answer: it was done by Sweden and Finland in the 1990s. It requires serious fiscal conservatism (aka “family hold back”) but the result, within a decade, could be a doubling of Scotland’s historic rate of growth and full employment. That is the prize of independence. Tory austerity is a different matter: cutting but not investing; concentrating wealth rather than creating it; imposing individual pain without hope of common gain.

There’s more to it than fiscal prudence. There would have to be simultaneous moves to raise labour productivity, domestic savings and investment. Public sector efficiency would have to go up every year continuously. Show determination in these areas and the markets will lend at realistic rates, allowing time for business tax cuts to work through.

What about oil? Last week I suggested the Scottish Government could manage any short-term volatility in oil revenues during this transition period by mortgaging some portion of future oil receipts and investing the proceeds. That would create an income-bearing capital buffer. Should oil receipts drop unexpectedly, this nascent oil fund could supplement the budget using either or both capital and income. Again, it would reassure lenders, reducing the risk premium on Scotland’s sovereign debt.

John McLaren and Brian Ashcroft have attempted to refute my general proposition by arguing (essentially) that the scale of forward sales of oil would be so large as to be impossible, if they were to make a practical difference. Their calculations deserve detailed refutation in a place that will not tax Scotsman readers over their porridge. For now, let me say both these critics exaggerate the downward volatility of oil revenues during any transition, and the capital buffer required.

Consider: between 2000 and 2005, Scottish pro rata oil revenues averaged £3.866 billion per annum, with the worst year (2003-04) dropping to £3.378bn, a variation of £488 million, or 1.1 per cent of that year’s Scottish budget. Hardly a crisis.

For the half decade to 2010, oil yielded an average annual income to Scotland of £6.417bn – if we leave out 2008 when commodity prices rocketed before the credit crunch. The volatile year in this period was 2009-10, when the variation was £1.224bn below average, or 2 per cent of the total Scottish budget. That’s not negligible, but neither is it destabilising. And it was more than offset by the near doubling of oil revenues the year before, which John Swinney would have banked.

What Messrs Ashcroft and McLaren are contesting is not the economics of independence but of the transition to independence – an admittedly complex period. In doing so, they ignore – deliberately? – the policy mix that could transform the Scottish economy permanently.