Potholes litter Scots' high road to independence

If the Scottish Nationalists win the argument, in two years' time the country will vote to break away from the UK, but asks Ben Chu will it be able to stand alone?

'The noblest prospect which a Scotchman ever sees, is the high road that leads him to England" said Samuel Johnson. That opinion will be put to the test in the autumn of 2014 when the Scottish population will be asked whether they wish to dissolve their three-century marriage with their southern neighbours.

One recent opinion poll found that the proportion of Scots who would favour independence would fall to just a fifth if it left them £500 a year worse off. That suggests the deciding factors in the referendum could be whether Alex Salmond's Scottish Nationalists are able to persuade the electorate that it would be financially better off breaking away from the rest of Britain. It is a question that the Institute for Fiscal Studies will examine tomorrow in the first of a series of reports on the issue sponsored by the Economic and Social Research Council.

So what would an independent Scotland look like in economic terms? We can give the broadest of outlines. Scotland is one of the UK's most prosperous regions, considerably richer than Wales or Northern Ireland. Its unemployment rate of 8.1 per cent is almost exactly the same as the rest of Britain. Its independent GDP, according to an analysis by the Scottish Executive, would be between £127bn and £149bn (see chart). That would make Scotland slightly smaller than Greece. But beyond those vague contours a mist as dense as Highland fog descends.

The economy of an independent Scotland would depend on the settlement agreed with the rest of Britain. Here we examine the issues that would help determine an independent Scotland's economic future.

Currency: Would an independent Scotland launch its own currency?

That would be dangerous as small currencies are often subject to extreme volatility, which discourages internal investment. That's the last thing an open economy like Scotland, where exports account for 50 per cent of GDP, needs.

Alex Salmond used to be keen on euro membership, but in light of the eurozone turmoil he has leant instead towards retaining sterling. It's not clear whether this would mean a currency union, or a peg, but either way Scotland's interests would probably be neglected by a UK-centric Monetary Policy Committee.

Interest rates would be set by the Bank of England for economic conditions throughout the remaining territories of the UK, not Scotland. There would also presumably be no quantitative easing for an independent Scotland in a future slump.

The currency question leads to the issue of Scottish banks. If a future Edinburgh administration wanted the Bank of England to continue to act as lender of last resort to the Royal Bank of Scotland and others, the Bank would also need to oversee Scotland's financial regulation.

If Edinburgh wanted to take on the job itself, it would presumably find bondholders looking closely at the fiscal capacity of the Scottish government to rescue its banks if they ever got into trouble. The RBS's balance sheet at its pre-crisis peak was around 13 times the size of Scotland's GDP. One would expect some rapid, and painful, deleveraging if it became a purely Scottish bank.

Government finances: The UK's national debt will be around 75 per cent of GDP by 2014. How much of that would Scotland take with it?

Public-sector workers in Scotland have accumulated unfunded pension rights, too. Would an independent Scotland take on all of those liabilities? What about the guarantees of RBS'S liabilities?

If one presumes that Scotland takes on its share of all of these on a per capita basis, questions would be raised about Scotland's ability to meet its future fiscal commitments. It is unlikely that Scottish state debt would be awarded the AAA status that the UK currently enjoys from the credit rating agencies. If so, Scottish government borrowing rates on global capital markets would probably be higher than those of the UK.

There would be pressures from another direction. According to the Treasury (see above) public spending per head in 2010-11 was 18 per cent higher (£1,500) in Scotland than in England. The Scottish government puts the differential slightly lower, at 10.5 per cent. But either way, there is a gap. And this reflects the fact that devolved Scottish governments have been big social spenders, offering free university tuition, residential elderly care, lower prescription charges and other benefits. They have been able to deliver all this because of a regular subsidy from Westminster.

This implies that to close the deficit an independent Scotland would need to cut public spending or raise taxes. The former would hardly make Scots better off. On the latter, Edinburgh would be able to raise VAT, social security and income tax. But raising income tax would risk prompting migration to England.

The Scottish Nationalists say they could raise more funds by lowering corporation tax and attracting multinational relocators. Yet they would face tough competition from Ireland, which is already following this strategy. And corporation tax is falling in England, too.

Oil revenues: "It's Scotland's oil" was the nationalists battle cry in the 1970s when black gold was discovered in the North Sea.

The country's economic prospects post-independence could depend on whether that argument carries the day. Alex Salmond is demanding a "geographical share" of future revenues from North Sea oil and gas receipts for Scotland as part of an independence deal.

This would give Scotland 90 per cent of the remaining resources. The Scottish Executive estimates that if Scotland had such a deal in 2010/11 its tax revenues would have soared from £45.2bn to £53.1bn and the country's deficit would have fallen from 15.6 per cent of GDP to 7.4 per cent – a smaller level than the UK's in that year.

If Scotland received such a share of oil revenues post-independence the new country could, just about, maintain its current levels of social spending. But there would be long-run challenges.

North Sea oil output has peaked. Volumes have been falling by 6 per cent a year for the past decade and many North Sea fields are expected to run out in the next decade.

Scotland's public finances would also be at the mercy of the oil price. As the graph above shows, oil revenues collapsed in the mid-1990s. This was because the price of a barrel of crude slumped to $9. A future Scottish administration could find itself having to make rapid economies in response to falling global energy prices.

Conclusion

Independence is economically viable for Scotland. It is a high income country with a well-educated population and many competitive companies. But some very large questions need to be answered before it is possible to form a view on whether the Scotland would be financially better off breaking from the UK.

The AAA credit rating could go, interest rates could rise and its banks might face intense pressure to shrink their balance sheets. Scotland would need to negotiate accession into the European Union too. Other countries with separatist movements, such as Spain, might not be inclined to be welcoming. The rest of the EU might even demand that Scotland apply for euro membership.

Will Scotland secure a deal that effectively swaps Westminster subsidies for oil revenues? And if it does, how long will the oil last?

There are other imponderables. Scotland's growth has tracked the UK's reasonably closely in recent decades. Its mix of services, industry, manufacturing, agriculture has converged. But business start-ups have been lower. Could independence unleash an economic dynamism, and breath life into a new Celtic Tiger?

It's possible, but hardly guaranteed. So will the Scots be better off apart? The only honest answer is: it depends. The economic road looks set to remain covered in fog until well after Scots have cast their votes in 2014.