Full Fiscal Autonomy for Smarties

A guest post by Andrew Morrison

Anybody who follows the online continuation of the Scottish referendum debate could not help but notice the ever greater prominence of Mr Kevin Hague. He is becoming the poster boy of the unionist Twitterati who appear dazzled by his relentless pursuit of truth through rigorous economic analysis. Celebrity and media endorsements have come his way, prominent but shy economists back his work, and there has even been praise from someone who actually did Economics at Cambridge.

So, as a Yes-minded follower of the debate, I decided to bite the bullet and have a look over his work. Given the triumphalist fan club and his own assertive confidence, I didn’t expect to enjoy the read. There will undoubtedly be errors and approximations in the GERS figures, they do estimate only the economic situation whilst under UK management, and by focusing solely on government flows they are an incomplete analysis of the Scottish economy. However, I wasn’t going to learn anything about that from reading Mr Hague’s work – I just wanted to see what he had done with the numbers GERS gave him.

I was stunned. They say that evidence given under duress is usually unreliable and these poor numbers have been tortured to death. I can’t fully understand why he felt the need since the figures for the last couple of years will readily confess that this is not the brightest ever period for Scotland’s public finances. Perhaps he needed to show that this was a longer term pattern. Whatever the motive, the analysis appears that of an enthusiast who started with a preferred outcome in mind.

Now, I have some training in Economics but I would hesitate to present myself as some unimpeachable source of wisdom. I believe that what I am about to present is correct but I am happy to engage with anyone who can persuade me otherwise.

Can the United States afford fiscal autonomy?

This is an exact reproduction of Kevin Hague’s analysis of Scotland’s finances. The United States has government expenditure of $10953 per capita and Mexico just $2862 per capita. The US must fund this gap through raising higher revenue per capita. And indeed they do – US government revenue is $9425 per capita and Mexico just $2471 – an extra $6954 per capita.

That though is not enough to cover the extra spending of $8091 per capita. There is a shortfall of 8091 – 6954 = $1137 per person.

Multiply this figure by the US population of 321.4 million and you get a shortfall of around $365 billion. This is Mr Hague’s ‘deficit gap’ although the term, as he defines it, seems to lack any coherent meaning. He does at times describe it as how much ‘worse off’ a country would be, but I think deep down he knows that it is not. The headline message would certainly be that the US would have a $365 billion dollar ‘black hole’ if they don’t ‘pool and share’ their resources with Mexico.

That doesn’t sound right, does it? Yet, if our hero were to apply his GERS methodology that is exactly the conclusion he would reach. Something must be wrong and I see at least 2 important flaws. The innocent reader might be surprised to hear that both impact negatively on Scotland’s apparent position.

Error 1: Snow White’s ‘black hole’

Snow White and the 7 Dwarfs each pay £20 tax = £160

Snow White gets £27 of expenditure and the Dwarfs £19 each = £160

Income and expenditure are equal so there is neither surplus nor deficit. How much worse off would Snow White be if she left the family?

Surely she is £7 worse off. To maintain her current expenditure she must run a £7 deficit – she pays £20 into the pot but takes £27 out.

Kevin Hague thinks she is £8 worse off. To get this figure he compares her spending of £27 with the average for the rest of the family only (just the dwarfs) which is £19. This is a fundamental mis-understanding of the decision facing the young lady.

She is not choosing between being Snow White or being a Dwarf (in which case the £8 difference between the 2 options would be relevant). Instead her options are to be Snow White alone or part of ‘Snow White and the 7 Dwarfs’ – she can have a £7 deficit or no deficit at all.

Likewise, the US would be deciding between being an independent state or becoming part of the Amexican Union. The comparison should be between the US figures and the combined figures for both countries as that reflects the economic situation for the 2 possible outcomes. They are not deciding whether to be America or Mexico.

Mr Hague always manipulates Scotland’s additional public spending upwards by changing the comparison to one with the rest of the UK only (rather than compare with the UK with Scotland still in it). At times he openly ponders why others such as the IFS don’t make this adjustment. I have yet to see him question whether perhaps they are right and he is wrong.

Error 2: The 3 million zombies solution

We are challenged to explain how a fiscally autonomous Scotland could meet this artificially inflated ‘deficit gap’. Well how about we get invaded by 3 million benign zombies?

Now, generally speaking, your methodology is less than robust if it shows economic problems being solved by zombie invasions. The much-admired Mr Hague fails this test.

Consider Country X with a deficit of £1200 per capita and in a union with Country Y which has a deficit of £1600 per capita and a population of 7 million. Some people in Country Y would like greater control of their own finances but are told that they would have to overcome this ‘deficit gap’ of £2800 million (£400 per head times the 7 million people – I have left in the ‘Snow White error’).

Then the zombies arrive. They amble around quite harmlessly and life otherwise continues as normal – they don’t do any work but nor do they place any demand on state services. Country Y’s total deficit is 11,200 million (1600 per head x 7 million people). This has remained the same but the population has now grown to 10 million so the deficit per capita is now just £1120. This is a lower deficit than Country X so the problem appears to be solved – certainly Kevin Hague would no longer identify his ‘deficit gap’. (Indeed, if we now looked from the Country X point of view they have a ‘black hole’ in their finances.) But nothing of any economic substance has changed. There must be a methodological error.

The flaw is that we should not compare deficits in terms of ‘deficit per capita’ since this tells us nothing about the ability of that population to generate sufficient wealth to cope with the deficit. It matters who the 10 million people are and what they do. Some will be children, some retirees, others might be unemployed, perhaps the majority are low-skilled and earn low wages, and occasionally some are zombies. The number of people is no measure of how manageable a deficit is – it’s about how much income they generate. A £1000 per head deficit might be no real problem to a wealthy nation but catastrophic to a poorer one.

For this reason, no reputable comparison of national deficits will use ‘deficit per capita’. Instead the deficit will be compared to the annual value of economic output i.e deficit as a percentage of GDP.

This measure passes the zombie absurdity test. The total deficit didn’t change and the value of economic output (GDP) didn’t change. The arrival of the zombies didn’t change the economy and the ‘deficit as percentage of GDP’ metric confirms this.

This also now explains another huge chunk of the $365 billion that the US appeared, albeit implausibly, to be losing by not uniting with Mexico.

From the earlier figures, the US had a deficit of $1528 per capita and Mexico $391 per capita. This gave a ‘deficit gap’ of $1137 per person for the Americans to overcome in a Hague-style analysis (endorsed by the economics editor of the Sunday Times and the editor in chief of Moneyweek). It feels rash to dispute such authority but surely some recognition is needed of Mexico’s much smaller GDP per head of $10539 as compared to US GDP per head of $54206.

This would give us Mexico’s deficit as a percentage of GDP as 3.7% ($391/$10539) while the equivalent figure for the US is just 2.8% of GDP. All other things being equal, the US deficit is more affordable than that of Mexico. The Amexican Union would actually result in a slightly higher deficit, in this much more meaningful sense, for the combined state than the United States currently experiences. That might not be the case in every time period, but we can say with certainty that they would not be dodging some fantastical $365 billion ‘black hole’ by pooling and sharing with Mexico.

Scotland’s GDP per capita is higher than that of the UK as a whole and so, other things being equal, a slightly higher per capita deficit should be sustainable. The difference is not of United States/Mexico proportions but it is persistent and significant. By conducting his analysis in terms of ‘deficit per capita’, Kevin Hague removes that advantage. He treats a £200 per capita deficit as equally significant for both parts of the UK. This ignores that the meaningful measure (% of GDP) would show this as a lower deficit for Scotland than for the UK as a whole.

Taking a look at GERS

By this stage I had resolved to recreate Mr Hague’s favourite graph with the 2 corrections that I felt necessary. I would compare Scotland with the UK as a whole and analyse in terms of deficits as percentages of GDP rather than on a per capita basis.

So I opened up the GERS report 2013-14 fully expecting that I’d have to search around for the relevant figures and then perform whatever calculations would be needed to apply my improvements. There were no calculations needed. Absolutely none. The graph that Kevin Hague should have drawn is the very first thing in Chapter 1 of the GERS report. It compares Scotland with the UK as a whole, and it measures deficits as percentages of GDP. It is shown both in terms of current spending only and in terms of total spending. The GERS people knew what was needed for a relevant analysis.

He must have seen this – as I say it is the absolute first thing in the very first chapter of the report . Perhaps he didn’t like the news. It is certainly less conclusive than what he produced by taking the data from that perfectly good graph and distorting it with poorly justified ‘improvements’.

As I’ve said, I could be wrong and it certainly gives pause for thought that the other side of the debate don’t seem troubled by any such self-doubt. However, I am confident enough to propose a wager. My proposal is that we submit both this piece and Mr Hague’s ‘Full Fiscal Autonomy for Dummies’ to the economics department of every university in Scotland and invite comment. If there is a decisive outcome (say 2 to 1 or more) the loser would pay £50 to a political organisation of the winner’s choice.

In the event that I lose, I’ll still console myself with the knowledge that it’s a £50 loss as opposed to the £100 ‘deficit gap’ that Kevin Hague thinks he would be risking.

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