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.


  1. "the currency would likely collapse under the weight of enormous public sector deficits and trade deficits."

    Why? Where else are the exports to Scotland going to go?

    The exporters to Scotland will need to start saving in Scottish pounds or they simply won't be able to sell their wares there.

    When the Euro 'collapsed' against the Swiss Franc, what happened?

    1. Given that the Scottish pound would be a new currency if there were enormous trade and public sector deficits there would likely be a speculative attack on the currency in the foreign exchange markets.

      Exporters selling to Scotland would have no control over this.

    2. There would likely be a speculative attack on the currency market as in the currency would trade lower relative to other currencies? By itself, that hardly constitutes a collapse of the monetary regime.

      Also the effects of the decline in the fx rate on trade patterns are not nearly as straight forward as you presume them to be. Take a look at what has occurred between the Japanese trade balance as the yen has traded lower since the shift in the policy stance.

      Exporters are never in complete control of a situation. They can only influence or react to such shifts in the fx rate. Like, Neil state, exporters still have the choice in determining whether it makes sense for them to continue to export to Scotland in exchange for balances denominated in Scottish pounds. If exporters don't want to run/hold these balances, this would mean they would reduce the degree in which they export to Scotland. This in itself reverses the trade deficit which you seem to worry about.

      As for a currency collapsing under the weight of public and trade deficits (both of which are linked to one another), these balances are outcomes which result from decisions taken by a confluence of entities. The numerical balances in themselves don't lead to collapse. There is usually much more going on when such disruptions occur. See what is happening in EM now or in cases of past hyperinflations. Much more going on.

    3. Rafael,

      The currency collapse with those magnitudes of deficits weighing on a brand new currency would likely look something like the Icelandic krona after the 2008 crisis. You'd likely see a devaluation of between 30% and 50% and the inflation caused would be enormous. Likewise, since Scots rely on imports for consumption their standards of living would also fall drastically.

    4. The Icelandic Krona and the Icelandic monetary regime still exists. As what happened to the Icelandic system in 2008, surely there were many forces at play internally and externally which caused conditions to shift. There is a difference between a currency collapse and an fx rate trading down (even drastically). The latter could lead to a total collapse in the monetary regime, but as your example points out it very well may not.

      Scotland's living standards would decline IF exporters reduced their trade with the nation (which isn't a certainty as seen in Japan which is running larger trade deficits after the yen has traded down) AND if Scotland failed to adjust to this outcome overtime. If FX rate declines to the point where exporters reduce their trade, but the Scottish system adjusts by improving and developing a vibrant domestic economy, the situation may very well improve over time.

      Also the relationship between changes in the fx rate and inflation is a complicated one. The Yen has declined over 20% relative to the dollar since 2012 and the rate of inflation has barely picked up. There are other forces at play.

    5. No. Imports decline if the price increases internally cause consumers to stop buying them. It doesn't matter what exporters do. They have no control over this. It is a phenomena known as the "import elasticity of demand".

      As to the yen, inflation didn't increase because the majority of Japanese products are bought internally. Comparing Japan to Scotland is not viable because most of Scottish consumer goods are bought abroad.

    6. "Imports decline if the price increases internally cause consumers to stop buying them." which is the other side of this "exporters reduced their trade with the nation " Both sides adjust/respond to the change in conditions.

      "Comparing Japan to Scotland is not viable because most of Scottish consumer goods are bought abroad."

      Which is the point I was trying to make when making the comparison and stating:
      "Also the relationship between changes in the fx rate and inflation is a complicated one."
      "There are other forces at play."

      You are describing some of those factors.

      As stated in my previous reply, I suspect the change in living standards over time after such an adjustment would depend on how Scotland adjusts internally. If Scotland adjusts by increasing domestic production of consumer goods which were once imported from abroad then living standards would not necessarily decline. This would lead them toward becoming less reliant on foreign manufactured consumer goods.

      If that is not possible, then I agree with you where such a move could very well result in a drastic decline in living standards.

    7. Ah the myth of the 'speculative attack'.

      Given that the UK is the major exporter to Scotland, then a few 'liquidity swaps' from the Bank of England will provide whatever UK pounds are required to allow the export transactions to complete - leaving the Bank of England as the saver of last resort in Scottish pounds.

      And that's because the UK needs the exports - or people start losing their jobs!

      Anybody who believes that floating rate currencies are a 'free market' really needs to get out more.

  2. An interesting pair of graphs. I suspect however that, though volatile, the price of oil/gas can only go up, as there is little sign of any serious investment in alternatives.

    1. Perhaps you would care to check out today's post on this issue for more information?

  3. Mr. Gradualis (and friends), I reviewed your blogger profile but found little to enlighten me. I had hoped to learn about your background and motivations. I only learned that you are a secretive 'think-tank'. Frankly, a bad start.

    From your analysis on sectoral balances, I am hoping you know something about MMT and functional finance? They might make you think more deeply about a fiat currency and the purpose of borrowing it from the private sector. Or not, if you have any mainstream economics dogma programming.

    1. lsembard,

      Sorry, we have yet to launch the main website which will have all the details of our think tank. Hopefully it will be up and running in the next week or two.

      And, yes, we are well aware of the MMT and functional finance paradigms and are including them in our analyses.