Key Messages from the International Conference on the Economics of Constitutional Change

Published: 8 October 2013
Author: David Eiser

This blog originally appeared on The Economics of Constitutional Change website

The International Conference on the Economics of Constitutional Change, held in Edinburgh on the 19th and 20th of September 2013, brought together leading academics and policy makers to review the Scottish independence debate within the context of wider international experiences. Speakers from Ireland, Belgium, Lithuania, Catalonia and Spain, Quebec and Canada, explored the constitutional change experiences and debates in their respective countries, focussing particularly on the actual and anticipated economic costs and benefits of constitutional change. UK-based speakers presented papers considering how a range of issues – including currency and debt, spending and taxation, migration, the energy sector, and ambitions for social justice – might influence the costs and benefits of various constitutional change options and scenarios.  This blog summarises the key messages of each paper; the slides for each presentation can be viewed here.

The conference heard from two countries which achieved independence during the 20th century – Ireland and Lithuania. In both cases, independence paved the way for economic diversification both internally and with external trading partners, although strong links remain with the former state.

Frank Barry described Ireland’s transition from poor region of the UK prior to independence in 1922 to a country which had achieved parity in living standards with the UK and EU by the 2000s. He focussed particularly on key decisions in the late 1950s and early 1960s, when Ireland’s attempt to reduce its trade dependence on the UK switched from a protectionist stance to one of outward orientation, underpinned by the introduction of export-profits tax relief (the precursor to Ireland’s low rate of corporation tax) and entry into the EEC in 1973. The Irish economy still has strong links to the UK – indigenous Irish firms remain highly focussed on the UK market, and the Common Travel Area Agreement between Ireland and the UK allows mutual freedom of travel, residence and employment. However, his conclusion was that economic sovereignty did eventually enable Ireland to achieve a strong diversification of external trade, capital and migration flows which have underpinned its success.

Ramunas Vilpisauskas described Lithuania’s transition from a centrally planned to a market economy after re-establishment of its independence in 1990, following 50 years of imposed Soviet rule. This transition has involved radical restructuring of Lithuania’s economy (which was orientated towards Soviet military requirements), creation of market institutions (such as a banking system) from scratch, and a re-orientation of political and economic linkages with the wider international community. Lithuania’s accession to the EU and NATO in 1994 and has become an important way for Lithuania to enhance its bargaining power and manage its relations with Russia. But Lithuania maintains important links with Russia, particularly in relation to energy supply. The author hypothesises that ongoing diversification of Lithuania’s energy competition and infrastructure will reduce the scope for Lithuanian politics and energy supply to be influenced by Russian suppliers, which in turn is a fundamental precondition for a ‘less suspicious bilateral relationship’ between the two countries.

The conference heard from three countries in which there are strong movements for constitutional change: Belgium, Spain and Canada. In all three, economic factors are a key factor underpinning demands for independence, although cultural and linguistic differences are also important.

Marcel Gerard described the evolution of Belgian federalism since 1970 as a progressive series of six reforms. Each reform has granted more autonomy to the three Belgian regions, Flanders, Brussels and Wallonia. The reforms have often been driven by relatively wealthy Flanders, but resisted by Wallonia, which receives significant inter-regional equalisation transfers from Flanders. In 2014 Belgians will vote simultaneously in European, federal and regional elections, the outcome of which may trigger a seventh reform of state. The pressure of such reform is likely to be in favour of further autonomy for the regions, which would ‘reduce Belgium to an empty shell’. However, Brussels position as simultaneously the capital of Belgium, Flanders and the French-speaking community (despite its geographical position within Flanders), reduces the likelihood of a Belgium separating. Neither the French-speaking nor the Flemish speaking communities are willing to give the city up to the other. Thus ‘Brussels forces Belgium to keep going’.

Jesus Ruiz-Huerta and Antoni Castells outlined the Catalonian demand for independence within the context of Spain’s regional financing system and the economic crisis. Catalonia is one of 15 Autonomous Communities (ACs) in Spain that are financed through the ‘Common regime’, where some fiscal autonomy is combined with fiscal equalisation across ACs. The remaining two ACs, Basque Country and Navarre, and funded through the ‘Special Regime’ which is akin to the concept of ‘devo-max’. As a relatively wealthy region, Catalonia has always perceived that it is unfairly disadvantaged through the equalisation system. But Catalonian demands for independence have increased in recent years, largely triggered by a ruling of the Constitutional Court that elements of the Catalan Statute (which clarified the distribution of competencies between the Catalan and Central Parliaments and which had previously been approved by both the Catalan and Spanish Parliaments) were unconstitutional. This ruling was viewed symbolically by the Catalonian nationalist parties, acting as ‘the spark that lit the fire’ of Catalonian demands for independence.

Sovereignty is now firmly within the Catalonian political mainstream (while in much of the rest of Spain, there is a sense that devolution to the ACs has gone too far and should be partially reversed). Nationalist parties were elected to the Catalonian Parliament in November 2012 following a pledge to hold a referendum on independence. However, it is unclear as to where the balance of responsibilities lies between the Spanish and Catalonian parliaments regarding the legal jurisdiction for the referendum process. Even with 80% of Catalan opinion in favour of holding a referendum, the Spanish government has refused to accept the concept. Castells thus argues that ‘the real struggle is not yet for independence, but for a referendum on self-determination’.

Castells considers the likelihood of several different future scenarios for Catalonia. First is a move to a federalist structure within Spain, with greater tax autonomy for the ACs, less horizontal equalisation, and participation of ACs in decision making of the state; however, the failure of process around the Statute of Autonomy is argued to have left this scenario ‘deadly wounded’. Second is a special deal for Catalonia, possibly inspired by the Basque/ Navarre arrangements, although there are no specific offers on the table at the moment. Third is Catalonian secession from Spain. This scenario brings with it a number of complex cost and benefit considerations: the trade-off between the reduction in fiscal transfer to the rest of Spain versus a decline in trade with the Spanish market; the allocation of debts and assets of the Spanish state; the economic benefits of gaining political decision-making power; and the costs of potential exit from the EU and Eurozone.

The tensions between the Spanish and Catalonian governments have echoes in the Canadian/ Quebec case. François Vaillancourt described the sovereignty debates in Quebec, in relation to the referendums in 1980 and 1995, and in the period since. Failure of the Meech Lake Accord in 1990 was interpreted by many Quebecers as a rejection of their hopes and aspirations by ‘English Canada’, the result of which was a sharp rise in support for sovereignty, which paved the way for the referendum on ‘sovereignty-association’ in 1995, which was only narrowly defeated. Since then, the Supreme Court of Canada has declared that Quebec does not have the right to unilaterally decide its independence, and that the House of Commons has the responsibility for determining any future referendum question, and what size of majority would constitute a clear will to secede; the government of Quebec has indicated however that it does not feel bound by this law.

Continuing the Quebec story, Louis Massicotte discussed the role that perceptions of the economic consequences of secession have played in influencing support for Quebec independence. He argued that motivations for secession have been driven by culture and identity more than economic arguments, but that fear over the potential negative consequences of secession (particularly in the short-run) have reduced support for independence. Quebecers are more likely to support the idea of ‘sovereignty’ rather than ‘independence’, ‘secession’ or ‘separation’. As a result, the debate within Quebec has tended to have been framed in terms of Quebec becoming a sovereign state, while maintaining some kind of economic association with the rest of Canada (drawing on the European Common Market model).

Vaillancourt then considers two empirical questions: first, whether uncertainty over Quebec’s future has impacted on its economic performance; and second, what would be the short-term economic ‘shock’ effect on Quebec should it become independent. In relation to the first question, he finds limited evidence that political instability has been detrimental to Quebec’s past economic performance; however, the short-run economic costs of a “Yes” victory in a future referendum are expected to be significant, in terms of higher borrowing costs, reduced GDP, and some out-migration (largely by non-Francophones, although some out-migration of Francophones is also anticipated).

Papers from the UK authors highlighted that independence would bring opportunities but also constraints. David Phillips presented a detailed analysis of the pattern of public spending in Scotland. His analysis shows that total public spending in Scotland of £67bn (including devolved functions, welfare spending, and per capita shares of defence spending and debt interest) was 11% higher per capita than in the UK as a whole. If a newly independent Scotland in 2016 were to follow the same scale of fiscal consolidation as set out by the UK Government, this would imply cuts to public spending in Scotland of around £2.5b in its first two years. Phillips’ analysis shows that the fiscal sustainability of an independent Scotland will depend heavily on tax revenues from North Sea oil and gas – current OBR projections forecast these to decline, increasing the budget deficit of an independent Scotland by a further £3.4b.

Uncertainty around North Sea oil and gas revenues was a theme addressed by Gordon Hughes, who examines the economic issues arising from the role of energy in the Scottish economy. He argued that although independence would afford Scotland greater control over its energy resources and ensure that a higher proportion of resource rents accrue to the population of Scotland, these advantages must be weighed against the increased risk associated with the volatility of international markets in energy and other natural resources. This led him to argue that it is unlikely that it would be sensible for an independent Scotland to commit itself to a fixed exchange rate with either the pound sterling or the euro.

Currency issues in the face of uncertainty around debt splits and oil revenues were the focus of Angus Armstrong’s paper. He considers three currency options for an independent Scotland – a sterling currency union, an independent Scottish currency, and the euro. The optimal currency option for Scotland is likely to depend on a number of uncertain factors, including the level of debt that an independent Scotland would inherit, and the value of its oil and gas exports. A key message from the paper is that, for an independent Scotland to prosper, its solvency (i.e. its ability to repay and service debts) must be beyond doubt, and that expectations play an important role in judging solvency.

Armstrong argues that, as a new state, an independent Scotland would face higher borrowing costs than the UK. He quantifies the likely magnitude of this borrowing cost premium, and, under given assumptions as to the likely value of Scotland’s debt on becoming independent, Armstrong estimates that Scotland would need to run primary surpluses of 3.1% annually in order to achieve a debt-to-GDP ratio of 60%; this would represent a ‘very tight’ fiscal tightening. Armstrong argues that the greater the amount of public debt an independent Scotland assumes, the greater the importance of retaining some policy flexibility and the stronger the case for introducing a new Scottish currency. A problem here is that there has been ‘no meaningful discussion to date between the two governments on dividing the existing UK public debt’. Armstrong concludes that ‘a definitive answer to the currency question is impossible as long as this issue is unresolved’, and that ‘the credit standing of both the UK and a future independent Scotland are at risk from uncertainty over how the UK’s existing debt will be divided’.

Robert Young’s paper provided insight into the reasons why a debate around how the UK’s debt and assets might be split has been lacking. His paper explores the factors that are likely to influence the level of transition costs to independence. Transition costs can be thought of as the short-term costs associated with the process of achieving sovereignty. Robert Young argues that these transition costs can be substantial, and may alter the calculation of the net benefits of independence. He identifies three main types of transition costs: transaction costs (disentangling and re-creating institutions), fiscal costs, and perhaps most significantly, the costs associated with uncertainty. Some of these are fixed costs, but most are variable, with the magnitude of these costs depending crucially on the degree of political cooperation between the different players in the independence debate. Using a game theory framework, Bob Young demonstrated that it may be rational for each side to raise the eventual transition costs through non-cooperation. In theory, transition costs can be reduced, but the scope for doing so is often limited: pre-commitment to certain arrangements is extremely unlikely given that it is in the ‘yes’ sides interest to downplay the costs but in the ‘no’ sides interest to highlight them in great detail; and pre-negotiation is further limited when the UK government also represents Scotland and its interests.

These themes also emerged in Bell et al paper which focuses on trends in Scottish migration and the implications of constitutional change. Their analysis reveals substantial gross flows of migrants between Scotland and rUK. These flows have been relatively balanced, without any obvious detriment to either labour market. In addition, in recent years there has been an increase in the significance of in-migration from overseas, relative to migration from rUK, in contributing to Scotland’s population growth. The authors argue that Scottish independence would bring risks (potential for reduced migration between Scotland and rUK which might eventually lead to productivity decline) as well as opportunities (such as the opportunities for Scotland to develop its own in-migration policy in response to specific skills shortages and – arguably – a slightly more open attitude to in-migration than is witnessed elsewhere in the UK). There remain however many uncertainties as to the impact of Scottish independence on migration, such as those relating to Scotland’s relationship with the EU (and the Schengen Treaty), and how immigration and welfare policy might interact.

The issue of how an independent Scotland might vary welfare policy, and to what end, was addressed by David Comerford and David Eiser. In light of statements from the Scottish Government that an independent Scotland would seek to achieve a more ‘Scandinavian’ welfare system, their paper considers the extent to which a Scottish tax/benefit system could deviate from that of the UK under an independence scenario. The level of labour mobility between Scotland and rUK, as well as the extent to which preferences for redistribution differ, is likely to influence the extent to which independence, further devolution, or simply different policies under the current constitutional framework are most effective in enabling Scotland transition to a less unequal income distribution.

There were many important messages from the Conference. Independence will almost certainly bring with it short-term costs associated with transition. The longer term costs and benefits are more difficult to predict as they will depend on a variety of uncertainties on issues such as global energy prices, the way that debt and assets are split, institutional arrangements, and the extent to which policy divergence post independence might limit factor mobility. Such uncertainties could be damaging to the UK and Scotland in the near-term. And although there is scope for some of these uncertainties to be reduced through political cooperation, it is not always realistic to expect key agreements to be made before the referendum.

Importantly however, the debate in Scotland is taking place in an open and transparent way, which is not to say without any acrimony, but certainly with a level of cooperative dialogue that has not always been seen in independence debates elsewhere. It is planned that a selection of the papers presented at the conference will appear in a special issue of the Oxford Review of Economic Policy in the early part of 2014.

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