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Fiscal Commission Working Group – First Report – Macroeconomic Framework

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3: Summary: Macroeconomic Framework

  • This chapter provides a short summary of the emerging macroeconomic framework.
  • It covers monetary policy, financial stability and fiscal policy.
  • A more detailed discussion of the framework is provided in Chapter 9.

Introduction

3.1 By international standards Scotland is a wealthy and productive country. There is no doubt that Scotland has the potential to be a successful independent nation.

3.2 Even excluding North Sea oil output, GVA per head of population in Scotland is estimated to be 99% of the UK average and the highest of any part of the UK outside London and the South East. When the value of North Sea output is added the size of the Scottish economy increases by around 20% [5].

3.3 Scotland has key strengths, particularly in sectors such as food and drink, life sciences, digital industries and tourism. Scotland also has a global reputation for science, engineering and creativity. And despite the recent challenges, the financial sector in Scotland continues to perform well, particularly in areas such as asset management and insurance. Scotland also continues to remain an extremely attractive location for international investment.

3.4 In energy, Scotland is one of the richest nations in Europe. It is estimated that there could be up to 24 billion barrels of oil and gas remaining in the North Sea with the vast majority located within Scottish waters. At the same time, it is estimated that Scotland has around 25% of all of Europe's potential offshore wind and tidal energy, a tenth of Europe's wave power potential, and an estimated 50% of Europe's potential offshore storage capacity which provides opportunity in carbon capture and storage.

3.5 The Scottish economy also faces challenges. Many of these have persisted over decades. Scotland's long-term historical growth rate has lagged behind that of many of its peers. Between 1977 and 2007, Scotland's average annual growth was 2.3% compared to 2.8% for EU countries of a comparable size [6].

3.6 As a country rich in natural resource and skills, there is no obvious underlying characteristic of the Scottish economy that can explain this underperformance.

3.7 Scotland's business start-up and entrepreneurship rates have been lower than both the UK average and key international competitors. The country's universities rank as some of the world's elite, but in other areas of innovation such as business expenditure on research and development, Scotland has lagged behind key competitors.

3.8 Many of the key economic policy levers which could be used to tackle these challenges are controlled by the UK Government. Under the current arrangements for example, the Scottish Government/Scottish Parliament is directly responsible for 7% of its own revenues - a figure that will rise to 16% under the Scotland Act 2012. Other areas of policy such as economic regulation, international transport connectivity, employment policy and international representation are also largely reserved to the UK Government.

3.9 The issue is not that Scotland is necessarily burdened with poor policies but that the centralisation of economic policy levers means that specific policies - particularly in key areas - cannot be tailored to the specific structure, opportunities and challenges of the Scottish economy.

3.10 Scotland is also currently part of a UK economic model and society which is one of the most unequal in the OECD. Inequality within the UK has increased in recent decades. Such patterns of inequality will continue to have a negative impact on growth and prosperity over the long-term.

3.11 Under the current constitutional arrangements, however, this is an area of responsibility where the opportunities for the Scottish Parliament and Government to adopt a different approach are particularly limited.

2014 Referendum

3.12 The Scottish Government is committed to holding a referendum on independence in 2014. To support this, the Government will publish a White Paper on independence in the Autumn of 2013.

3.13 Scottish Ministers believe that independence is the key to unlocking Scotland's economic potential and the means to securing a fairer society.

3.14 In order for this to be achieved, a robust macroeconomic framework will be essential.

3.15 Failure to ensure macroeconomic stability risks undermining efforts to boost growth, improve employment prospects and tackle inequalities. Recent events - and particularly the inherent weaknesses in the model developed in the late 1990s and early 2000s - have highlighted the harsh reality of any failure to establish a robust and sustainable framework.

3.16 The Working Group believes that it is desirable - and in the interests of both Scotland and the UK - for both governments to enter into effective and meaningful dialogue on the proposition outlined below at the earliest opportunity.

Macroeconomic Framework

Principles

3.17 In 2009, in 'Fiscal Autonomy for Scotland: the case for change and options for reform' [7], the Scottish Government set out two clear overarching objectives which it believed should underpin the design of a macroeconomic framework:

  • long-term competitiveness - maximising opportunities to raise productivity, competitiveness, economic security and resilience over the long term; and
  • short-run responsiveness - maximising opportunities to respond swiftly and effectively to changes in circumstances.

3.18 To deliver on these objectives, the work of the Fiscal Commission Working Group has been focussed around four key themes:

  • Credibility - the framework should deliver confidence for businesses, investors, financial markets and the people of Scotland. The design of a robust and transparent framework is essential to enable policy makers to take advantage of the discretion and autonomy that independence would bring.
  • Sustainability - the framework should be affordable and support sustainable development - in the widest possible sense - over the medium to long-term.
  • Stability - the framework should provide coherent and predictable macroeconomic policies. It should also retain sufficient flexibility to respond to short-term pressures and unforeseen events.
  • Autonomy - the framework should seek to provide the maximum degree of policy autonomy. It should also be sufficiently dynamic to evolve over time to meet changing economic conditions or preferences.

3.19 The proposed framework takes as its starting point the status quo [8] and aims to be a workable model for day 1 of independence. The framework will be subject to negotiation with the UK, although the overall structure of the proposition is believed to be of benefit to both governments post-independence.

3.20 The proposal is designed to provide the flexibility to evolve over time in response to changing circumstances or requirements. Central to this is the establishment of a number of key institutions to build capacity and knowledge in Scotland to inform the future direction of economic policy and reform.

3.21 A central underpinning is the commitment by the Scottish Government to remain an active and positive participant in the European Union (EU). The government has made clear that it expects that Scotland's transition to independent membership of the EU will be negotiated from a position within the EU.

3.22 The outcome of these negotiations will have implications for the final specification of the framework. However the overall proposal is designed to be sufficiently flexible to meet the likely and realistic requirements of membership of the EU. The starting point therefore is the existing and expected future requirements for membership placed on the UK.

3.23 The framework has been designed with the overriding objective of delivering macroeconomic, financial and fiscal sustainability. This is entirely consistent with the key economic principles and objectives of the EU.

3.24 Discussion of the framework is centred upon three key pillars:

  • Monetary Policy - including the choice of currency and the framework for setting interest rates and the money supply to promote ('price') stability and minimise short-term volatility;
  • Financial Stability - including the use of prudential regulation, supervision and resolution tools to ensure stability in the financial system; and,
  • Fiscal Policy - including the setting of taxes, government spending and borrowing within an overarching framework of fiscal sustainability.

Monetary Policy

3.25 The choice of currency is a key determinant of the overall macroeconomic framework.

3.26 Analysis shows that it would be in Scotland's interests to retain Sterling immediately post-independence. It is also the case that - post independence - this would benefit the rest of the UK given the scale of integrated markets, including in areas such as financial services.

3.27 Scotland's economy is strong enough and sufficiently aligned with the rest of the UK that a separate currency would not be necessary. Retaining a common currency would promote the single market and help facilitate trade and investment to and from the rest of the UK and elsewhere.

3.28 There would be a number of ways to implement monetary policy within a formal monetary union, including options around the institutional arrangements for central banking.

3.29 The preferred model would be for Scotland to enter a formal monetary union with the rest of the UK with the Bank of England (the Bank) operating as central bank for the common monetary area (the 'Sterling Zone').

3.30 Ownership and governance of the Bank could be undertaken on an agreed shared basis, reflecting Scotland's current implicit and historical share of the existing Bank's assets as a UK institution. This arrangement would be subject to negotiation with the UK Government. However a practical arrangement with shareholder rights allocated on a per capita or GDP weighted basis would seem appropriate.

3.31 Monetary policy would be set in the Sterling Zone according to economic conditions in both Scotland and the UK - in the same way as is currently the case.

3.32 The Bank would remain operationally independent to set monetary policy.

3.33 This would involve little change in the day-to-day operations of the Bank or in its discharge of monetary policy. The common payments and settlements system would continue, as would the efficient use of inter-bank money markets as the principal means of providing liquidity. The Bank's balance sheet could remain unified, albeit indemnified by two fiscal authorities.

3.34 As part of this arrangement, the framework proposes that the Scottish Government should seek input into the appointment process to key positions within the Bank (for example the Monetary Policy Committee (MPC) and Financial Policy Committee (FPC)) and an input into its remit and objectives. A representative from the Scottish Treasury could also attend MPC meetings in a capacity similar to the existing HM Treasury representative (i.e. in a non-voting capacity and to ensure that monetary policymakers were fully informed of developments in Scottish Government economic and fiscal policy).

3.35 Related to this, and as an explicit shareholder of the Bank, the Scottish Government and Scottish Parliament should seek a role in providing oversight of the Bank and its activities.

3.36 This would create an appropriate system of accountability and representation for both governments.

3.37 Matters of collective decision making on governance and accountability could be addressed within an overarching agreement on the functioning of the Sterling Zone. A shared institutional arrangement, such as a 'Macroeconomic Governance Committee', could be established to oversee matters which require coordinated input and/or agreement from the respective governments. This practical arrangement could cover not just monetary policy, but also issues of shared interest in fiscal sustainability and financial stability. Such an arrangement would also provide a forum for knowledge transfer and the sharing of key information.

Financial Stability

3.38 The crisis of 2007/08 has highlighted, perhaps more clearly than ever before, the importance of financial stability and the potential damaging effects on the real economy of financial crises. There are three key aspects related to this - effective supervision, resolution and deposit protection.

3.39 The failure of regulatory authorities and governments - particularly in countries with globally significant financial institutions such as the UK - to fully appreciate or identify the emerging risks in the financial sector directly led to the sharpest economic slowdown since the 1930s.

3.40 In response, policy makers across the world are actively reappraising the frameworks and institutions needed to monitor financial stability and reduce the probability and scale of future crises. A particular challenge for all countries in the increasingly interconnected global economy is the existence of large multinational financial companies with complex cross-border structures.

3.41 This is an area of on-going reform. For example, the UK Financial Services Act 2012 will overhaul the system of financial regulation in the UK. As part of this, the Bank of England is also being given a stronger role in financial stability. In Europe, the first stages of a 'Banking Union' are being implemented which include a single cross-national supervisory mechanism and forthcoming proposals for more robust frameworks for resolution and deposit protection.

3.42 It is therefore essential that any proposed macroeconomic framework for Scotland takes these reforms into consideration and is sufficiently flexible to be able to respond to these on-going developments.

3.43 There are a number of major financial institutions which are incorporated in Scotland - but with significant headquarter functions elsewhere in the UK - that are integral to the overall stability of the UK financial system. Similarly there are a number of major London based financial companies with substantial systemic presence in Scotland. The framework takes this into account and the consequent merits for financial stability - in both countries - of a coordinated approach.

3.44 The proposition has been developed around aspects of financial stability from a macroeconomic perspective:

  • Supervision and Oversight - a framework to proactively pre-empt instability in financial institutions, the sector as a whole, or instability in the wider economy caused by the actions of the financial sector;
  • Crisis Management, Resolution and Deposit Protection - a framework for quick and efficient solution to crises that ensures confidence in the financial system.

Supervision and Oversight

3.45 As background, it is important to note that aspects of financial regulation are driven by internationally set rules and standards. As part of this context, in order to meet financial supervisory and regulatory roles, EU Member States are required to designate one or more independent competent authorities to oversee financial regulation. There are a number of institutional structures and arrangements that Scotland could adopt to achieve this.

3.46 Given the close linkages between macroeconomic stability and financial stability, the core proposition is for key elements of prudential regulation (both micro and macro [9]) to be discharged on a consistent basis across the Sterling Zone.

3.47 This would also ensure that systemically important institutions which currently operate across the Sterling Zone were supervised on a common and consistent basis. This could be discharged either by the Bank on behalf of the Scottish Government or by a Scottish Monetary Institute (see Chapter 9) working in partnership with the Bank.

3.48 Macroprudential regulation would also be aligned in its new role to provide a valuable additional tool for promoting macroeconomic stability alongside monetary policy. In time - and as the use of macroprudential levers are refined - options to undertake spatial variation of such policy could offer a new mechanism to further boost stability and help to address any variations within the monetary union.

3.49 Other areas of financial regulation (i.e. elements which are not as closely tied to financial stability), such as consumer protection, promoting choice and other 'conduct' aspects, form a linked though distinct, aspect of the regulatory environment. This could be discharged in Scotland. The framework takes into consideration EU rules and requirements and, in particular, the opportunity for institutions legally established in other Member States to largely operate without further authorisation requirements throughout the EU (i.e. 'passporting').

3.50 There is merit in ensuring a degree of consistency given the broadly integrated financial services sector (both within the UK and increasingly Europe). Moreover, in certain areas it is recognised that there would be relatively strict alignment to satisfy commonality in related prudential areas to ensure financial stability across the Sterling Zone.

Crisis Management and Resolution

3.51 In addition to supervision and regulatory issues, the framework enshrines an effective resolution mechanism and protection scheme for deposits and other financial products.

3.52 Financial crises require close coordination of monetary, fiscal and macroprudential policy. At the centre of the framework is the proposition for issues of crisis management, resolution and deposit protection to be coordinated on a pan-Sterling Zone basis. This would be consistent with the powers and authority of the Bank of England under the UK Banking Act 2009 and would also reflect the integrated nature of the highly developed financial services market and the need for co-ordinated action to deal with cross border financial institutions. It would also be consistent with the emerging principles underpinning the proposed Banking Union in Europe.

3.53 While these activities, in all but the worst of financial crises, are likely to be conducted at arms-length from government, for example by the central bank and financial regulatory authorities. If and when any input was required from a fiscal authority - for example an indemnity was sought to underwrite a particular intervention - this could be coordinated through the 'Macroeconomic Governance Committee'.

3.54 Depending upon the nature of the intervention this could be undertaken jointly by both governments in accordance with the shareholder framework as set out above. This would deliver a fair, common and effective approach to ensuring stability across an integrated financial and monetary area.

Fiscal Policy

3.55 Within this macroeconomic framework, fiscal policy would provide the key new levers for the government to grow the economy and to tackle challenges in Scottish society and Scotland's economy.

3.56 In addition to aligning spending priorities and policies to the unique circumstances of the Scottish economy and the preferences of the people of Scotland, opportunities would exist to put in place new tax and economic regulatory systems.

3.57 It is clear that as a result of both the position on UK public finances prior to the financial crisis, and the scale of the negative impact of the downturn itself, Scotland and the UK will face a challenging fiscal envelope for at least the next 5 years irrespective of the constitutional framework.

3.58 This does however, present an opportunity to establish a new framework that promotes fiscal sustainability, learn the lessons of the past and put in place strong foundations of responsibility to underpin future growth and prosperity.

3.59 It is assumed that the Scottish Government would inherit a fair and equitable share of historic UK public sector liabilities and assets. There are complex legal issues surrounding transferring existing UK Government debt, particularly around the definition of 'successor state'. A transitional arrangement whereby outstanding debt was gradually transferred to both countries while the Scottish Government continued to meet its share of existing obligations, would seem to be a sensible and efficient solution. There are various technical ways in which this could be achieved.

3.60 In order to promote stability within the proposed monetary union, there is merit in putting in place a fiscal sustainability agreement with overall objectives for ensuring that net debt and government borrowing do not diverge significantly. This should cover both governments and be credible. Within this overall envelope there would be the freedom to vary taxation and spending.

3.61 Given the relative importance of oil and gas revenues to the Scottish economy, and the prospects for volatility in revenues from this sector, the framework looks to incorporate a stability fund to manage oil revenues. The Scottish Government should plan budgets on a cautious estimate for oil revenues and invest any upside volatility in the form of higher tax revenues in such a fund. This could then be used to guard against future unexpected falls in revenue or asymmetric shocks. With careful management of the public finances over time, such a fund could evolve into a more general wealth fund to promote inter-generational equity.

3.62 In response to a previous recommendation from the Council of Economic Advisers in 2009, the Scottish Government agreed to establish an independent Fiscal Policy Commission alongside moves toward greater autonomy. As part of the framework, it is envisaged that this Commission would have a wider role than simply a body to oversee the transparency and robustness of economic forecasts, with a clear objective of advising on economic and fiscal policies. This would help provide credibility to markets and potential investors.

Scottish Monetary Institute

3.63 Related to this, and to ensure that fiscal policy decisions were fully informed of developments in the Scottish economy in areas such as monetary and financial stability, the Scottish Government should establish an independent Scottish Monetary Institute. This should be independent and transparent but accountable to the Scottish Government.

3.64 This institute could take responsibility for a number of key functions including, research into the Scottish economy, monitoring of developments in the financial sector and data collection. It would work closely with the Bank of England. There may also be a synergy from bringing together other key macroeconomic functions, such as debt management, in such an independent body.

3.65 It is envisaged that such an institute would also be a key focal point and reporting body for EU-wide institutions and structures and international organisations such as the IMF and the OECD. The gradual build-up of such institutions would also increase the flexibility and range of potential macroeconomic options for Scotland in the decades ahead.

Conclusion

3.66 The framework outlined above provides a broad overview of the proposition for a macroeconomic framework for an independent Scotland.

3.67 The proposed structure takes the status quo as a starting point. It is designed to be robust, flexible and attractive to key partners in the rest of the UK and the EU, while at the same time providing significant policy autonomy to Scotland. Ultimately the exact framework will be negotiated with these partners, and many of these discussions may not take place until after the referendum. However, the Fiscal Commission Working Group is confident that such a framework provides a basis for productive negotiations on an agreed way forward and can evolve in the light of changing circumstances.

3.68 From the perspective of the UK - if there is a vote for independence - the Working Group believe that this framework would be to their benefit. It would for example provide a consistent and transparent framework to manage the transition process. The UK would also retain an integrated market with a key trading partner. As approximately 10% of the existing UK economy (roughly the size of the entire financial services industry in the UK), Scotland would remain one of the largest trading partners of the UK economy. There would be particular advantages for the UK in areas such as energy and financial services.

3.69 Moreover, the model proposed for monetary policy, financial stability and fiscal policy offers fully engineered frameworks in key areas of interest to the UK. For example, the proposals for financial stability would ensure that major financial institutions based in Scotland and operating in the rest of the UK would be subject to similar levels of oversight and scrutiny (and vice versa).

3.70 It has been claimed that a model of monetary union poses Euro Area style risks to Scotland. However, the proposed framework summarised above is quite different. It contains a number of mechanisms which overcome the design problems of the initial Euro Area model. It starts from an existing shared currency, and incorporates key elements of fiscal and financial stability policy, underpinned by two economies which are structurally, cyclically and institutionally more aligned than the members of the Euro Area.

3.71 It is designed to be flexible and evolve should the people of Scotland wish for further reform in the future or should economic conditions change post-independence.

3.72 The structure proposed however, would represent a major step change in the economic powers and responsibilities of the Scottish Parliament and Scottish Government. It would ultimately provide full control, in terms of economic sovereignty, to the people of Scotland.