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The Scottish gamble

• Evan Davis | Notes on Real Life |
• 30 Apr 07, 08:58 AM

Scotland is not voting on independence next Thursday. But with the SNP leading in the polls, it is interesting to ask what economic cases can be built for or against an independent Scotland.

Indeed, lots of economists are taking to the newspapers and airwaves to offer a view.

Here's mine.

It starts with the basic premise that Scotland has two things that England does not.

The first is a disproportionate level of UK funded public spending. The second is oil, the revenues of which are taken by the UK government.

If Scotland were independent, it could expect to lose the UK funded public spending; but it could expect to gain the oil money. In the short term, that's the fiscal choice Scotland would be making if it decided to leave the UK and go it alone.

As it happens, the choice is a fairly balanced one at the moment. The oil money Westminster takes, more or less pays for the "extra" public spending Scotland enjoys.

I'll give you the exact figures on which I base this claim as I know these things are much argued about and are very fraught.

The oil money in the fiscal year just ending would be worth 拢8.6 billion to Scotland, assuming that the Nationalists are right in asserting the country would keep 95% of the total UK 拢9.1 billion oil revenues.

The public spending "bonus" that Scotland was budgeted to enjoy in the 2005/06 year (the latest available) was worth about 拢1,500 per person. That was the difference between per capita government spending in Scotland and in England. Multiply that up by Scotland's 5.1 million people (and multiply it up by about 6.2% to bring it forward to 2006/07). In total, the public spending bonus on my calculation then comes out at 拢8.1 billion.

So - loosely speaking - Scotland gives the UK 拢8.6 billion of oil money, and the UK gives Scotland 拢8.1 billion of extra public spending.

Now, given the uncertainties of this debate, that's about all the data you need to make a short term assessment of Scotland's "viability" as an independent nation. If Scotland had been independent last year, and had stuck to the same spending policies, it would have had a government whose fiscal position was not that different to that of the UK.

A lot of debate has been stirred by this however. You can read about the competing claims in my postscript below. The Scottish Executive claims about Scotland's deficit make it sound unviable; the SNP claims make it sound as though Scotland is in surplus. The truth I think lies in between. On my calculation for last year, I think Scotland would have had a deficit of 拢3.5 billion, which would have been manageable.

But as I say, the detail you can read below.

However, does all this statistical banter matter?

Probably not much. The short term is not the best horizon over which one should assess Scotland's viability.

The choice to take money out of the North Sea rather than out of the Westminister Parliament would have long term implications.

And one negative implication in particular, is that an independent Scotland would be very dependent on oil.

Oil would be vital to sustaining the current level of Scottish public spending, accounting for a fifth of government revenue, and about the same proportion of national income.

And yet, at some stage, the oil will run out or diminish. Or the price will fall. And then what?

The argument that the oil money can be put into an endowment fund for Scotland's future doesn't add up because the oil money will have already been used to pay nurses and teachers.

But there is an upside to independence. Scotland could make some different decisions to those it鈥檚 allowed to make right now.

It could cut defence spending very heavily, because as a small country, it can free ride on the defence of its neighbours. It can cut corporate taxes and attract international companies which would bring extra revenue in. The UK can't do the same, for fear of provoking retaliation from other big countries.

So it's not impossible to envisage a Scotland that would re-invent itself into a high growth dynamic economy.

The decision to go independent then, involves a gamble: that Scotland could re-develop itself better as a separate economy than as part of the UK; and that it could do so before the huge oil economy faded out of its current significance.

It's a gamble because we don't know what will happen to oil, and nor do we know how successful Scotland will be at reinvigorating its economy.

It could go right, as it has for Ireland in recent years. Or it could go wrong, as it did for Ireland in the first few decades of its history.

However, there is one other implication of independence. And this is perhaps the most important, and the least predictable.

Would it move the political centre of gravity in Scotland?

For London-based journalists, it is striking just how far left of England, Scotland's politics lies.

How would independence affect that?

Some Scots think that if only Scotland could free itself of the tyranny of English capitalism it would become more socialist. After all, Scotland's devolved government is restrained by Westminster in its spending, and through the disciplines of the Labour Party in the radicalism of its policies.

But there is a counter-argument. That independence and fiscal autonomy would make Scotland not more socialist, but more like England. When government spending is paid for directly by taxation on Scotland's own middle class, that group may be less inclined to vote for it.

Or to put it brutally, when the oil money ran out, if Scotland had not reinvented its economy, it would have to learn pretty fast how to do so. There would be no security blanket, and the desire for a tax-financed public sector to shore up the economy may diminish.

I'm not sure which way this debate goes, but it is interesting that a number of market-oriented economists - such as John Kay - are beginning to see the merits of independence as a possible "kick up the bum" factor to a Scotland that can be accused of low aspiration compared to its economic potential.

Now, economists are in demand in this election. But they can't give definitive answers to the important questions about Scotland's future. They might be able to pontificate about the short term fiscal consequences, but that's not where the real argument should be.

It's the growth capacity of the nation that matters for its economy. And there's far too much uncertainty surrounding that, for any detailed statistical banter to be very illuminating.

For the Scots the decision to remain or not remain part of the UK, has to involve some leap of faith.

Continue reading "The Scottish gamble"

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Is the China effect over?

• Evan Davis | Small Change |
• 17 Apr 07, 01:28 PM

A few thoughts on inflation.

For the last few years, the biggest risk to the strong performance of UK economy has been inflation.

It has seemed fairly tame, and even-higher oil prices in recent years did push it worryingly high.

But the risk has long been that we would discover that underneath our strong economy, was brewing some hidden inflationary pressure.

If that emerged, it would imply that some of our recent economic success had been built on shaky foundations: it would mean that interest rates had perhaps been "too low", that the borrowing we have done on the back of low interest rates was less affordable than we thought, that the house prices we have paid on the back of easy borrowing are unsustainably high, and that any sense of consumer wealth deriving from higher house prices is a mere illusion.

Indeed, for quite a while, one has been able to imagine the benign conditions of the last few years unwinding if inflation materialised. And that's why economists have been watching it so closely. It is not just about the discomfort of higher prices.

Well, has this inflationary pressure now materialised, or is just a blip?

Certainly it could be a blip as inflation is volatile at the moment, largely as a result of energy price swings. We can soon expect the measured inflation rate to fall as last year's energy price rises drop out of the twelve month inflation rate. And it may fall further as this year's energy price rises push the rate down. And then we can expect it to rise again in a years time, when this year's falls also drop out of the twelve month rate.

So we have to see through that volatility and ask where inflation will settle. That should be well below three percent, but there is still room for concern.

It all comes down to the China effect. In recent years, our economy has been dependent on deflating imported goods prices. To some extent, we've been able to enjoy simultaneous fast domestic growth, strong consumer spending and low inflation, because the prices of manufactured goods have been falling each year.

If the flow of cheap imports dries up, either because the Chinese export prices rise or because our exchange rate falls, then we have to adjust the domestic economy to slower growth and restrained consumer spending.

Today's figures show some worrying signs that manufactured goods prices are picking up. Furniture, toys and games, clothes and textiles all get an honourable mention in the statistical press release, as exerting upward pressure on prices.

One theory is these are going up in price now, as we've reach the end of the gains to be derived from out-sourcing our factories. When there are no more factories to send abroad, there are no more cost-savings to be found in manufactured goods prices.

An alternative theory is that these price rises were merely a pre-Easter one-off, as shops raised prices in anticipation of cutting them again to boast of special offers over the holiday weekend. On that view, they'll unwind in the figure next month.

It's too early to be definitive on whether or not it's time to call an end to the era of ever-cheaper imports, but its certainly a factor to watch.

The other factor to watch is the exchange rate. It has been relatively high, and in recent days strengthening against the dollar. As most Chinese imports are priced in dollars, they are going to get cheaper not more expensive when converted into pounds. But unless the pound rises forever against the dollar - which is unlikely - the exchange rate provides just temporary shelter against import price rises. Don't learn to rely on it.

My own view is that the lesson from the last few months' news on inflation is that if we know we are relying on some potentially temporary factors in keeping our inflation rate down, we might want to be more cautious in economic policy.

Instead of running the economy at a fast speed with inflation pushing at the top end of the tolerable range, you would prefer to have a safety margin, so that if the worst price risks do materialise, there's less of an adjustment to be made.

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The metric system

• Evan Davis | Notes on Real Life |
• 16 Apr 07, 09:39 AM

I'm often seen as something of a numbers man by colleagues around here. Because economics reporters often deal with statistics, they are meant to be good at arithmetic.

In fact though, in the absence of a calculator, my arithmetic is not very good at all. I lie awake in terror of being caught in , making a basic error in a rudimentary multiplication. (Mr Byers, you might remember was the school standards minister when he was asked on Radio Five Live what eight times seven was, to which he replied 54. It was perhaps an unfair question as most people's cognitive functions fail them under the pressure of live radio).

But I can tell you this. There are two numbers I find it very easy to multiply by: one and ten. I virtually never make a mistake with those.

And indeed, with a little care I find 0.1, 100 and 1000 pretty straightforward too.

I'm sure that others must be the same as me, which is why it is surprising that there is not more will in our country to finish the job of metrication.

In truth, we are mostly there with one gaping exception: distance. We just can't wean ourselves off miles, feet, inches and yards.

But wouldn't our lives ultimately be easier if we did?

Driving across long distances in Canada I found that kilometres are not particularly difficult to master. Of course, the distances sound very large (the "Calgary 470" sign makes it seem a longer drive than "Calgary 294"). But the good news is you make much quicker progress in kilometres as the numbers go down much faster.

Some people regard the imperial units as more intuitive than the metric system: the number twelve for example, has a particular appeal for those dealing in small, whole integer quantities because you can divide it by 2,3,4 and 6 and easily multiply it by 2 or 3.

Which is why we sell eggs in dozens or half dozens. And in fact that's why the French sell eggs in dozens and half dozens too (as they do snails, I'm told) despite their long metric history.

But 12 is a not a very good way of talking about units that are broken into fractions, where the advantages of base 10 assert themselves more strongly.

Anyway, the intuitive appeal of the number 12 would only be a strong argument for the non-metric system if most non-metric units were built around the number 12. But they are not. And even in the most striking case where they once were, the 12 penny shilling, few people yearn for a return to it.

As it happens, when it comes to distance, both systems have a similar-ish short measure (inch or centimetre); a medium measure (yard or metre) and a distance measure (mile or kilometre).

But the overriding advantage of the metric system is that its three measures all build on each other in a simple way, whereas there's really no logical connection between the three non-metric measures at all. A yard is 36 inches; a mile is 1,760 yards.

The non-metric answer is to have an intermediate unit, the foot, which sort of works in tying inches to yards, but doesn't help tie yards to miles.

All in all, it's pretty obvious that the metric system is easier once you've mastered it.

And as an example of its simplicity, take the hectare. Few of my generation seem to know that this basic unit of area is defined as 100 metres by 100 metres. It couldn't be clearer once its been explained, and then you can work out there are 100 to the square kilometre.

Instead, we persevere with the acre, which most of us have a vague sense of, but few of us can properly define as 69.6 yards by 69.6 yards. (If they ran a 70 yard race in the Olympics, we would all have a more precise idea of the area embraced within an acre - but unfortunately they don't.)

I wouldn't want to exaggerate the benefits of having basic units and sub-units of a measurement system that relate to each other in consistent ways. We can express time in days or years, and there is no simple conversion between the two. And we can talk of area in square yards, or in acres making no attempt at all to flip between one and other.

And using imperial units doesn't stop us using base ten or sub-units of tenths. We can use calculators to add up miles with decimal places, as easily as we can kilometres. It is more common to talk of a marathon as being 26.2 miles than 26 miles, 385 yards. In fact, we can deal with inches or miles in 10ths and 100ths without relating them to each other at all. Why not?

But it is clearly more helpful if the different units we use for short and long distances lock together for one good reason - the fractions of the bigger unit then have an obvious natural interpretation in terms of the smaller unit. And we don't need to grasp as many units at all. And we can convert between different units without using a calculator.

This is all obvious really. So why do we not make the change to kilometres right now?

First, there's obviously a bit of admirable British scepticism of grand, idealistic designs. Metrication is perhaps seen by some as another kind of worthy and impractical initiative like . Good idea but we can get on with real life now.

But that's not stopped the old empire dumping imperial measures, and moving to the de facto global standard: metric units.

Perhaps more significant in our reticence to finish the metrication job is a bit of "not-invented here" syndrome in our view of these things, exacerbated by our suspicion of too many things being imposed on us by Brussels.

Ironically, though, in many respects our view of metrication provides the best example of the British not rejecting a French imposition, but imitating French attitudes towards globalisation. Holding out against global norms and insisting on doing things our way, however inconvenient it is to ourselves.

Given that our language has done us so proud in this latest era of globalisation, it's odd that when it comes to numbers, we have such an anti-globalist view of things.

As it happens, I think the real reason we don't change is not that we dislike the fact the French invented it, nor that we have a tendency to behave like the French in facing globalisation. It is that in any given year, heaving ourselves through the transition to metrication is a difficult process.

It was jokingly argued when we switched to decimal currency, that as the change is most confusing for older people, we should wait until they die before proceeding. We can delay and delay as long as want on this count.

But it really comes down to a basic question - whether the cost of a switch-over is more than outweighed by the long term benefits of moving to the new system.

Upfront cost versus longer term benefits.

Economists are pretty familiar with this kind of choice: any investment has this basic structure. And economists have the tools to take a detailed look at investment proposals to decide whether the long term benefits are large enough to justify the initial payment. Some investments are worth proceeding with. Others are not.

So, if we view metrication as an investment, should we not take just such a detailed look?

Before we decide to stick in perpetuity to the system we've got, would it not be a good idea for someone to take a close look at really how costly it would be to switchover and what the benefits are, rather than leaving it to the mere default choice of doing what we always do?

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The state of trade

• Evan Davis | Small Change |
• 12 Apr 07, 10:24 AM

While members of the World Trade Organisation spend much of their time arguing about potential reforms to the rules of global trade, (or trying to limit the impact of the rules they've already agreed), the secretariat of the organisation in Geneva gets on with the job of overseeing the trade that is already going on.

And the WTO publishes its annual overview of world trade this morning. (You should be able to find it on ).

For trade boffins, there are a number of interesting things in it. I can't think of just one to highlight, so here are some bullet points to bring you up to date on the state of trade...

1. Trade continues to grow fast, notwithstanding the failures of trade negotiators to agree on new trade rules. World merchandise trade (i.e. trade in manufactured goods or commodities) grew by 15 per cent in 2006. Trade in commercial services grew by 11 per cent. (These figures take no account of inflation).

2. The WTO expects trade to have a rougher time in 2007 as the world economy is expected to grow less quickly than last year.

3. Trade involving the least-developed countries was strong in 2006, with the value of their exports up 30 per cent. This was driven by higher prices for oil and other commodities. But in addition, there was no evidence that China's surging exports of textiles have come at the expense of the poorest countries. For example, exports of textiles and clothing from least-developed countries to the EU grew by 30 per cent.

4. The world's biggest exporter is the US, followed by Germany and then China. Japan is fourth and Britain is fifth.

5. In terms of exports of goods alone (which account for four-fifths of global trade), Germany is the world leader, with the US second and China third.

6. China's exports of goods grew by 27 per cent last year. Indeed, in the second half of 2006 they overtook those of the US showing that as of now, China is probably the world's second largest goods exporter.

7. India's trade performance does not make it one of the big players. It is the world's tenth biggest exporter of services, but only ranks as the world's 28th biggest exporter of goods, with a one per cent share of global exports.

8. A third of Britain's exports are services, the highest proportion of the world's top 10 exporting nations.

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That pensions raid

• Evan Davis | Notes on Real Life |
• 2 Apr 07, 03:48 PM

What have we learnt about Gordon Brown's first Budget from the release of a set of 1997 Treasury documents about it?

In truth, not perhaps as much as some of the commentary might imply.

It is not the case that Gordon Brown was warned not to proceed with the tax rise on the grounds that it would damage Britain's pensions system.

Instead, he was given some detailed and equivocal advice about the consequences of what he was proposing, with the overall suggestion that the pension system would suffer as a result of it, but would probably end up coping with it adequately.

In many respects, that advice is unsurprising. The tax change that Gordon Brown implemented was not one that he had thought of out of the blue. It was a much-discussed idea familiar to people in tax circles. And it was so obviously a tax on pension funds, there could never have been any doubt in the minds of ministers or officials as to its implications.

If there had been any doubt, it was dispelled by Geoffrey Robinson's memoirs, . He had been paymaster general at the time, and had helped Gordon Brown and Ed Balls devise a package or corporate tax changes back when they were in opposition. He makes quite clear that they were fully aware of the losers.

Before outlining some thoughts on what the episode tells us about our pensions industry, and the chancellor's role in its downfall, it's worth having a bit of background on the tax system itself, and the reforms Gordon Brown made in his first two Budgets.

What Gordon Brown wanted to do was raise about five billion pounds. And his idea was to reform the particular way that corporation tax and income tax overlapped, in their treatment of company dividends.

There is a long history to this, and of awkward interactions between the two tax systems. It is an issue that all developed countries grapple with.

In what's called a classical corporation tax system, company profits are hit with corporation tax. And dividends paid out of those profits are then hit with income tax in the hand of the recipient shareholders. (Some shareholders - like pensions funds - are exempt from income tax, so they don't pay income tax obviously.)

It was actually Harold Wilson's Labour government which introduced this corporate tax system to Britain in 1965.
But the classical system has long had critics who argue it is unfair because profits paid out as dividends are being hit by two taxes.

The opposite of the classical system is known as the imputation system, which removes the double tax. And in 1973, Britain (under a Conservative government) decided to opt for something called partial imputation. Corporation tax was paid on all profits, but when receiving their dividends, shareholders were allowed to assume that basic rate income tax had already been paid on their dividends.

Part of the corporation tax was in other words, counted as a pre-payment of income tax. This meant shareholders should have avoided paying the double tax on the same income.

In practice, this system was implemented in a complicated way with implications beyond the remit of this article. But it's worth knowing that the tax bill was divided into two: the company paid advance corporation tax at the basic income tax rate on dividend pay outs. And then later, paid any remaining corporation tax owed (the corporation tax rate was higher than the basic income tax rate, and there were the profits not paid out as dividend to be taxed as
well).

In keeping with the imputation principle, those shareholders who were not meant to pay income tax, were thus entitled to an income tax rebate. That mainly affected the pension funds.

However, in our progression from the classical to partial imputation systems, the most striking fact now was that some shareholders were in effect paying no tax on dividends, even though retained earnings were taxed. In particular, concern grew that this gave too much of an incentive for those shareholders to seek dividend pay-outs.

So what Gordon Brown did in 1997 was to move us someway back to the classical system.

It was a wide-ranging package over two Budgets that cut the headline rate of corporation tax, abolished advance corporation tax, brought forward the payment of corporation tax generally, limited the degree to which income tax payers could deem income tax had been paid on dividends, and above all, stopped the payment of tax rebates going to pension funds and others.

Was Mr Brown鈥檚 package more likely to lead to investment? Or to be neutral between retained earnings and dividends? Up to a point. (Although one consequence was that pension funds had more incentive now to structure their investments as loans, receiving interest rather than as dividends on shares, a potential boost to private equity).

But the most important thing about the reforms was simply that they raised a lot of money. That was the point of them, and once that goal had been satisfied, it was never very likely the Treasury could come up with a package to benefit the corporate sector.

So what does this whole story of the chancellor's first, big tax reform tell us? It doesn鈥檛 allow us to say he destroyed the pension system, for two reasons. Firstly there were enough other, bigger things going on that did more damage.

And secondly, it was open to us to keep our pensions alive, by investing more in them if we wanted to fill the hole he had left. The chancellor may have put an obstruction in the pensions road, but he wasn't driving the car that crashed into it. That was in the hands of employers who were free to increase contributions but chose instead to accelerate the closure of final salary schemes.

The story also doesn鈥檛 allow us to say Mr Brown fails to heed the advice of civil servants. The advice he was evidently getting in that particular case was far too ambivalent to make it impossible for him to have proceeded with the tax rise.

But the story perhaps did provide an early lesson on the way the chancellor likes to present tax changes. In many ways, it is similar to the episode around the last Budget, in which the Treasury's own assessment of its tax plans was so imbalanced, (in only presenting winners without presenting losers) that people felt cheated when the full implications of the tax package were spelt out.

Had the chancellor, back in his 1997 Budget, given a straight and open explanation of the extent of the tax rise, the risks attached to it, the advice he had about how much more we would need to put into pensions, about how small the positive effect on investment would be... then the delayed anger now erupting might have been rather diminished.

If he had told us that we needed to top up our pensions, then some of the worst effects might have been avoided by people topping up their pensions.

Or to put it another way, if the chancellor put an obstruction in the pensions road, he might have put a warning notice up, so unwitting drivers knew what to face.

But as it happened, anyone listening to his account of the tax change - and indeed, even the account given by Ed Balls this weekend - might have been forgiven for thinking it was simply designed to remove some technical distortions prevailing in the tax system.

They knew it was more than that. And the civil servants advice to them makes that clear for anyone who could have supposed otherwise.

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