Friday, 14 February 2014

Scotland's Dependence on Rising Oil and Gas Prices: A Question of Macroeconomic Stability

Yesterday on the blog we ran a piece that highlighted, through the use of the sectoral balances approach, that the Scottish macroeconomy looks completely different depending on whether we include oil and gas revenues or not. If we include Scotland's geographical share of oil and gas Scotland is a very rich country indeed. If we do not they are quite poor.

In that blog post we mentioned that even if an independent Scotland does get access to their geographical share of the North Sea oil reserves there still may be substantial macroeconomic instability due to the instability of oil revenues. Some readers wondered just how volatile these revenues might be.

Below we have included a graph that shows Scottish oil and gas exports as a percentage of GDP, Scotland's net exports as a percentage of GDP and finally the Brent oil price. (All data on Scotland is taken from the Scottish government statistics database while the Brent oil price data is sourced from FRED).

As we can see, Scotland's trade balances is dominated by oil and gas exports. When the latter rise/fall so too does the former. We can also see that Scotland's trade balance is, for this reason, extremely sensitive to movements in the oil price.

We should also note something rather important about the measures. Since we have measured oil and gas exports against GDP and since GDP is generally growing, in order for oil and gas exports to continue to buttress Scotland's trade surplus they must continuously grow in lockstep with GDP growth.

This means that, in order for Scotland to maintain a persistent trade surplus, either the price or quantity of oil and gas sold abroad must increase sufficiently over time to keep pace with GDP growth.

The fact of the matter is, however, that the amount of oil and gas Scotland sells abroad does not grow continuously over time. In part this is reflective of the fact that in order to increase the supply of oil sold abroad Scotland must make new oil and gas discoveries, and in part this is reflective of the fluctuations in the oil price.

The following graph maps the percentage change in total oil and gas exports against the oil price. What we see is a high degree of sensitivity of oil and gas exports to the price of oil.

Particularly concerning is that as the oil price has stopped climbing in the last three years the year-on-year increase in oil and gas exports in Scotland has fallen and even gone into the negative. This suggests that in the past decade Scotland has been relying on rising oil and gas prices to ensure that their oil and gas exports grew at pace with GDP.

This provides strong evidence for what we wrote about yesterday: namely, that an independent Scotland needs an extremely flexible macroeconomic framework which can deal with such potential shocks. To this we would now add that they also require a long-term plan because, as oil and gas reserves dwindle and price increases peter out, Scotland will need to replace this source of exports with new industries that are attractive to foreign buyers.

Thursday, 13 February 2014

A Tale of Two Countries: The Sectoral Balances of Scotland

When examining the Scottish economic statistics one thing immediately jumps out: namely, the dependence of just about every key macroeconomic variable on oil exports. 

Without taking into account the geographic shares of oil and gas the Scottish economy comes across as extremely weak. But once we include the geographic share of oil the Scottish economy comes across as one of the strongest in Europe.

Yesterday the Scottish government released an experimental data series estimating the amount of oil and gas exports and imports coming out of and into the country. By combining this new dataset with other datasets that have been published -- namely, the quarterly national accounts and the estimates of public sector revenues -- we can form a relatively complete picture of the Scottish macroeconomy.

The best way to see the overall macroeconomy is through the lens of the sectoral balances approach as pioneered by the great British economists Lord Nicholas Kaldor and Wynne Godley. The sectoral balances show what each sector is contributing to the economy at large. It is a basic accounting identity that shows how one sector's surplus is another sector's deficit and vice versa (a more thorough breakdown of the framework can be found here while a less technical discussion can be found here).

The simple intuition lying behind the sectoral balances framework is that if one sector is net spending another sector is receiving income and net saving. This framework can tell us a lot about the structure of the macroeconomy. For example, prior to the 2008 financial crisis many countries had large private sector deficits. This led to instability in these economies as the debts accumulated by firms and households became too large.

Likewise, in the wake of the crisis many countries today have very large public sector deficits. These allow the private sector, by accounting identity, to net save, deleverage and draw down debt.

Here we will lay out two different sectoral balances for Scotland. One will show the sectoral balances for Scotland if the geographical oil and gas exports are included. The other will show the sectoral balances for Scotland if the geographical oil and gas exports are excluded. What we see when we examine these is two very different macroeconomic pictures. Here are the graphs.

The differences between these two charts is so striking that it is almost difficult to know where to begin.

As we can see, in the first chart -- the one which includes the geographic share of oil and gas exports -- we see a very robust economic picture. The private sector in Scotland is in a healthy position of large net savings -- implying very strong balance sheets and a low level of net private sector debt. Meanwhile the government does not have very large deficits -- an unusual situation in a world where, since 2008, public sector deficits of upwards of 8-10% have become the norm.

The reason for this healthy economic picture is the large amount of oil and gas exports. These ensure healthy trade surpluses which provide an inflow of income into the country and buttress Scottish saving.

When we take the geographic share of oil and gas out, however, we get a very different picture. In the second graph it is clear that Scotland is, apart from oil and gas, a country with a very large trade deficit -- this deficit is about twice the size of the otherwise large British and American trade deficits. In addition to this, when you remove the revenue generated from oil and gas the public sector also tends to run enormous deficits.

The net result is that private sector balances sheets look far more precarious. The private sector basically relies on enormous public sector deficits for its rather meager net saving position. It is easy to imagine how, if a Scottish government denied of its oil and gas revenues (which, by the way, are extremely volatile due to price and quantity fluctuations) ever tried to engage in austerity to reduce the size of its public sector deficits the economic contraction would be enormous.

We can also see from the above graph that if Scotland ever issued its own currency and did not have access to its geographic share of oil and gas the currency would likely collapse under the weight of enormous public sector deficits and trade deficits.

There are a lot of lessons contained in the above two charts and we have only begun to hint at them here. But the easiest takeaway from these graphs is that there are indeed two Scotlands. One Scotland, the Scotland with its geographic share of oil and gas, is rich and stable with high savings rates. The other Scotland, the Scotland with no oil and gas, is poor and would be prone to macroeconomic instability due to its large public sector deficits and trade deficits.

If Scotland does decide to shoot for independence come September of this year it had better have access to its geographic share of oil and gas. And even in such a circumstance the country will require a robust and flexible macroeconomic framework in place to ensure stability when volatility is inevitably encountered in the oil and gas market. 

Update 14/02/2014: There have been some questions regarding just how Scotland's macroeconomy might respond to oil and gas fluctuations. In a post today we lay out the relevant statistics.

Note on sources: Despite enormous and valiant efforts on the part of the Scottish government and its statisticians, Scottish economic statistics are only in their most primitive phase. While the data seems so far robust it is presently only available for limited periods and for limited sectors. For this reason the above private sector balances are derived from the published trade and public sector statistics as they do not currently have an independent existence.

Monday, 3 February 2014

Carney’s Hedge

The media reaction to Bank of England governor Mark Carney’s speech in Edinburgh this week has been rather dramatic. Under the rather prosaic and dull title of The Economics of Currency Unions, Carney’s talk – given the time, timing, place and audience – was intended to be a ‘technocratic assessment’ of the pros and cons of the proposed currency union that is integral to the SNP’s plans for an independent Scotland. 

Rarely, I think, has a lunch lecture to business dignitaries on such a topic set pulses racing. Yet the London commentariat – despite their best efforts to hide their jubilation – figuratively jumped for joy when the governor made his speech. 

Of course, there has been a lot of hedging of late on the issue of Scottish independence – not least as most London-based national newspapers have relatively healthy circulations in Scotland and are chary of losing 6 million potential customers. Usually there is at least a pretence of impartial coverage. So it was interesting to see that their reaction to this speech – detailing a cornerstone of prospective SNP policy – nearly made them thrown caution to the wind and gloat over the central banker’s intervention. 

Of course, much of the coverage fell along the usual predictable lines; most outlets decided this was a disastrous intervention that boded incredibly badly for the Scottish nationalist road-map. More measured analysts paint Carney’s approach as a calculated effort to remain above the fray. But what precisely is Carney saying? Very few pundits have attempted to paint this as positive endorsement of post-independent Scotland’s monetary structures. Most have, instead, narrowed in on Carney’s concluding remarks that ‘‘a durable, successful currency union requires some ceding of national sovereignty’’. This is understandable, nor is it unusual to surmise that Carney would not endorse any pro-independent policy.

Carney is, after all, a political appointee and a deeply conventional economic thinker. When this fact translates into his position on any given policy, it is typical to conclude that his stance would be antipathetic to drastic alterations in the political or economic structures of the United Kingdom. It is therefore unsurprising that news outlets concluded that this was a ‘pounding’ of pro-independence aspirations.

If this is an operating assumption – and it is understandable to suppose so – then it might be worth applying this presumption of Carney’s conservatism to the structure and statements of his Edinburgh luncheon. That is, if our stating assumption is that Carney attempted to put a damper on the independence blueprint, we should look at how he went about it.

Firstly, the speech was structured in particular way. Roughly, it was a speech of two parts that got increasingly vague, incoherent and political toward the second half. After the usual flattery and platitudes addressed to his Scottish audience (Scotland’s great, thanks for the free lunch, Adam Smith etc.) Carney commenced with a brief – very brief – description of the benefits of currency union. These appear to be many, but were swiftly covered in the speech. Low transaction costs, mitigation of foreign exchange risk, access to liquidity, the maintenance of liquid markets, reduced borrowing costs (both personal and sovereign), increased trade and easier mobility for labour and capital all flew by in a few paragraphs. This was followed by the drawbacks of currency union in relation to independent monetary policy.

The second half is more interesting, but loaded with value-laden terms like ‘credibility’, ‘prudence’ and ‘stability’. There Carney indicated that a successful currency union would have to maintain a central bank (the Bank of England) as a lender of the last resort, a shared supervisory structure (the Prudential Regulatory Authority and the Financial Conduct Authority) and a common financial deposit guarantee and compensation structure (the Financial Services Compensation Scheme). It is worth noting that this does not depart from SNP plans for independence – these will all be maintained, with only the Financial Ombudsman Service becoming part of a ‘super’, all-inclusive consumer dispute resolution service in Scotland.

So, this ‘banking union’ is uncontroversial – it exists now and would continue to exist if the SNP had their way. But Carney’s next point best illustrates his conservative position. It is also indicative of the thinking that has sadly characterized economics in the last few years. The lessons Mr Carney seemed to learn from the Eurozone crisis seem firmly derived from the ‘peripheral irresponsibility’ school of thought. There is not room here to point out how silly and flawed this argument is – but applied to this debate, Carney indicated that fiscal policies in an independent Scotland would have to be limited and monitored from London in case a departure from ‘‘prudent behaviour’’ caused contagion in the wider currency zone. 

Furthermore, a bizarre argument based on moral hazard was put forward. Put bluntly, Carney stated that a currency union would incentivize reckless spending by weaker countries – because they were aware that they would be bailed out by the stronger country that had ‘‘run their finances prudently in the first place.’’ That is, that they would engage in reckless spending because the safety of the wider currency union would be jeopardized if they were not bailed out from the effects of their spending. The logical (in Carney’s argument) conclusion was an alleged need for ‘‘tight fiscal rules’’ – namely, control of national budgets that would render the intended results of Scottish independence negligible.
Obviously, this is both insulting and intended to pander to an ingrained idea of Scottish public-spending proclivity that is gaining increasing purchase in England. Let’s get it straight however – Carney’s argument is that currency union (without ‘tight fiscal rules’) would cause an independent Scottish government to spend too much due to their awareness that Rump UK would ‘bail them out’ eventually. This is nonsense. Does any government – or would any government – ever behave this way? Of course not. Most bailouts have occurred due to unforeseen systemic shocks or market shifts that reduce revenue, cause bank-runs or increase bond-yields. They don’t occur because a government consciously overspends due to the mercenary calculation that they will be ‘bailed-out’. 

Of course, this is meat for many opposed to Scottish independence. Yet there is something incredibly encouraging from Carney’s intervention. Firstly, it was terribly mistaken, but infinitely more measured than many other interventions (compared to, say, the Treasury’s shrill prognostications and jeremiads). It is also possible that Carney has no personal emotional investment in Scottish independence and was attempting to edge debate toward considering a separate currency altogether. Carney may also have been attempting a qualified endorsement of a currency union – with the tacit caveat that it would be difficult to operate. For all that, Carney did not hide his ideological stripes. He spoke as an austerian and betrayed the incredibly unimaginative nature of his economic thought – one that brought up the Euro-bogeyman frequently but doesn’t seem to have imbibed any real lessons from the Eurozone crisis.

Mark Carney probably went to Edinburgh intending to scupper the economic vision of the Scottish nationalists. That his contribution was so weak and vague is heartening – after disregarding much of the false assumptions and bad examples, a limited array of modified financial instruments and decent policies could, and should, be able to overcome the stifling limitations placed on Scottish economic policy before and after independence. Failing that, let us hope, at least, that some sort of imagination begins to be seen in tediously repetitive and acrimonious debate on Scottish independence.