The Scottish and Quebec Referendums Compared

Although I haven't made any statements on this issue, as a Brit I obviously have a viewpoint on whether Scottish independence would be good for Scotland and if so, whether this would be also good for the UK.

I also have a unique perspective on this particular referendum, which pundits and policymakers are comparing directly to the 1995 Quebec referendum for separation from the rest of Canada. I happen to have been in Montreal, Quebec on the night of October 30th, 1995, and delivered a report for the Canadian Broadcasting Corporation radio in Eastern Canada by phone early on the morning of the 31st, so I guess I know a little bit about close referendums. That referendum was incredibly close, with the "No" (to separation) vote obtaining 50.58% of the vote, and an incredible 98.18% of the electorate turned out to vote.

The similarity between the two referendums is uncanny, but there are some important differences between the Scottish and Quebec referenda, which have not been stressed in the media (see here for a selection from the BBC).

First and probably most obviously, Scotland speaks the same language as the rest of the UK, whereas Quebec is the only province in Canada that has a majority of French speakers, so they basically speak a different a language. That linguistic identity gives the Quebecois an added reason to seek sovereignty as they are recognized as "distinct" within Canada - to put it bluntly, in linguistic terms they are the only province where French is the first language in Canada.  That is not the case in Scotland.  Whatever you might think, language does give identity to nations.

Secondly, there are the geographic differences.  If Scotland leaves the United Kingdom, this indeed is the end of the 307 years political and currency union and the United Kingdom would consist solely of England, Wales, Northern Ireland and some smaller territories. That could have dramatic political effects, but it wouldn't impede movement of factors of production between what remained of the UK.  That could not be said if Quebec had left Canada.  Any casual glance at a map of Canada reveals that an independent Quebec would basically split the rest of Canada in two.  In fact 20 years ago when Quebec separation was a distinct possibility I remember the large degree of anxiety in the debate in Eastern Canada as Eastern Provinces realized that they would be small economies physically separated from the powerhouse of Canada, which is Ontario, as well as with all the other Western Provinces which make up the rest of Canada.

The other big difference is in terms of currency. When Quebec was looking at sovereignty, the currency question was a major problem for the Partis Quebecois under Jacques Parizeau.  The Bank of Canada stated that there was no guarantee that Quebec could continue to use the Canadian dollar after separation from the rest of Canada.  That left a void in terms of what the Partis Quebecois could claim in terms of what might happen in the event that the referendum approved separation from the rest of Canada.  There was talk of Quebec adopting the US dollar, of creating a separate currency (the Quebec franc) and of just using the Canadian dollar against the will of the rest of Canada.  With Scotland the Bank of England (led by a Canadian, Mark Carney, who perhaps remembers the uncertainty that the Quebec referendum generated in Canada) has declared that Scotland would be able to use the UK pound for two years after independence. And although there would have to be a choice made after two years about what would happen to the currency for an independent Scotland, there are feasible options, such as the adoption of the euro, which wouldn't entail any loss of monetary sovereignty (as the Scots would be able to make an input into euro area monetary policy whereas if an independent Quebec had adopted the US dollar it would have had to accept a "made in the US" monetary policy). Certainly if the euro is on the cards for Scotland then they would need to move fairly rapidly to set up their own central bank, as member states are not permitted to join the euro unless they have a central bank.

Source: The Scotsman.
http://www.scotsman.com/news/the-scotsman-cartoon-scottish-independence-eu-row-1-3213175

The point I am trying to make here is that Scottish independence is feasible economically ( - in contrast to commentators like Paul Krugman here and here, who seem to be fixated on comparing the Scottish situation to the instability of the early days of the euro area).  The big issue is whether it is desirable.  For the Scots it has just become a lot less desirable as two big UK banks (Royal Bank of Scotland and Lloyds) have said that they will move their headquarters south of the border, which would mean higher unemployment north of the border as those workers would be laid off or faced with moving south.  But on the other hand Scotland does have oil revenues, and does have a sizable industrial base already, so it would not be a complete disaster but would likely be mildly disruptive.  What is interesting as well is that in the final days before the Quebec referendum the Bank of Montreal, plus several other major Canadian companies headquartered in Canada also threatened to move their headquarters west to Toronto, so that is a commonality between the referendums ( - in fact the major move of Canadian corporations out of Quebec came after the first Quebec referendum in 1974).. But headquarters are usually symbolic in this instance as most of the business of banking has already located to where the clients are, and in Canada's case that is Toronto and in the UK's case that is most definitely London. So there wouldn't be a huge corporate downsizing in Scotland, and thus only a small number of private sector jobs lost. On the other hand, more government jobs would be created as UK government departments now serving Scotland from London would be redundant and new equivalent departments would be created in Edinburgh.  So from Scotland's perspective there are both economic costs and benefits which make the decision unclear.

For the UK's perspective it is clearly undesirable, as not only would they lose those oil revenues, but also it would alter the political equilibrium for years to come ( - as the Scots tend to either vote Labour or vote for the Scottish Nationalist Party (SNP), with a small number of constituency seats going to the Liberal Democrats), so that conservative governments would be elected in what remains of the UK for years to come. Single party dominant (uncompetitive) democracies are unhealthy ( - just look at South Africa if you need an example of this), and lead to complacency and corruption.  Also, losing part of the UK that is fairly well off will bring down the overall GDP per capita of the UK as the weight of the poorer parts of the UK (Wales and Northern Ireland) would be higher. Of course as only the Scots get to vote, the rest of the UK is beginning to realize these ramifications and is now turning up the heat to assure the Scots that they will gain greater political powers if they stay inside the UK, as did the Canadian government when it was clear that the Quebec referendum would be extremely close.

The decision is not an easy one, as not only is it a single decision that will affect a country for a long time to come, but also it is not a decision that would be easy to reverse for the Scots. This is what economists call "dynamic inconsistency" - in other words, what might be good in the short term, might not be good in the longer term or vice versa. I read a recent article in the New Statesman (see here) that talks about the "velvet divorce" between the Czech Republic and the Slovak Republic at the end of 1992, and how incredibly painful it was to begin with, but that now the Slovak Republic appears to be doing better than the Czech Republic in terms of economic growth.  The main point is that the economics depends on the terms of the divorce, which is a difficult thing to determine in advance. Nevertheless, the English are unlikely to make it easy for the Scots, so I think the first few years of Scottish independence would be extremely rocky.

As the 18th September (polling day) nears, I wouldn't be surprised to see the type of spontaneous outpourings of nationalistic pride in the current UK that would be similar to the mass rally that occurred in Montreal before the Quebec referendum, and indeed this type of emotional outpouring can sway undecided voters. The danger though is that the vote is extremely close, as this encourages the SNP to consider another attempt in the future ( - what the Quebecois used to call the "neverendum"), and indeed although the "No" side of the campaign has the powerful argument that independence is very difficult to reverse once it is achieved, the opposite holds true as well - that future referendums might then occur. The best outcome is that the vote is decisive - with either the "Yes" or "No" side gaining at least 55% of the vote.  Of course, that now appears unlikely, with all the polls that I am currently seeing indicate a very close run race..

The Unlikely Miracle of an Immaculate Monetary Exit

Recently, The Economist magazine reported (see here) that Richard Barwell of the Royal Bank of Scotland had made the comment that, for central banks to withdraw from the massive monetary stimulus they have delivered to the economy without any problems, then the stimulus should be withdrawn before the economy really is back on track again, and also for "central banks' economic forecasts to be unerringly accurate".  But in my view there is much more to this than just the timing of the withdrawal of the stimulus, particularly in the US, or the accuracy of central bank forecasts.

If one looks at the 10 and 30 year US government bond yields going back to the beginning of 2008, so just before the "great recession" started, from the chart below you can see that 10 year bonds were at 4% and 30 year bonds were at 5%.  What is astonishing about this chart is the big fall in US long bond yields that occurred in the late summer of 2011, and you might immediately assume that this marked the beginning of one of the "QE" programs of quantitative easing mounted by the Fed.  But you'd be entirely wrong here - it was essentially the beginning of "operation twist", where the Fed committed to buying more longer term Treasuries, or moving further down the maturity spectrum by buying more longer term bonds and selling shorter term ones.

We have never returned to those post-recession higher levels for 30 year bond yields ( - the 4-5% range), nor the 10 year bond ( - 3-4% range), despite having inflation that is roughly the same, if not higher than during that period.  Even during the "taper tantrums" of 2013, 30 year rates never quite got to 4%, and 10 year bond yields only briefly touched 3%.  Not only that, but the gap between the yield rates has been shrinking so that since early 2013 it is a full 0.5% smaller.

Let's have a look at real bond yields for the same maturity bonds (courtesy of the US Treasury's bond pages here). What's clear is that the "operation twist" announcement sent US 10 year real bond yields into negative territory for all of 2012 and the first half of 2013.  It's also noticeable that US real long bond yields are now not negative ( - but of course short term bond rates are). But it is also clear that it would be pretty exceptional circumstances that would send the US 10 year real bond yield into negative territory. In other words, to quote the pop band Yazz - "the only way is up"!

That also makes sense when considering both inflation and real GDP.  Current inflation is 2.1% on a year over year basis in June,   and current real economic growth on a year over year basis in Q2 is at 2.43%, not at all bad, considering the set back to output that the economy had in Q1 due to all the bad weather. Heck, some components in the CPI are just skyrocketing - such as Meat, Poultry, Fish and Eggs (up 7.5% yoy).  These are all products that we eat, and no doubt they will feed into higher grocery bills pretty quickly.  These levels of macroeconomic performance hardly warrant long interest rates in nominal terms at 2.5% or in real terms at 0.25%.

 

In other words, I would expect to be seeing both short and long interest rates at much higher levels than they are right now, but particularly longer rates, given that the economy is likely to be going through more rapid growth going forward than it has in the recent past.  All these predictions about continuing sluggishness in the economy have been underpinned by the Fed's continuing commitment to low interest rates ( - Yellen's claim that the FOMC is in "no hurry" to raise rates), and their "gradualist" ( - some might say irresponsible) and non-differentiated taper. 

 

And that is the danger.  The "gradualist" approach might be just a tad too gradual - and stimulative.  As central bankers are fond of saying, the Fed's job is to pull away the punch bowl just as the party gets going. But in my view the trouble is that the Fed is still spiking the drinks, when already some of the party guests appear to be a little tipsy. 

 

One of the biggest dangers that Fed Chairperson Janet Yellen faces is that she doesn't act quickly enough. After previous recessions, the Fed was often too late in tightening policy and the result was having to rapidly adjust interest rates upwards extremely quickly. Unfortunately the slowdown in Q1 might have laid a trap for the new Fed Chairperson, in that it was a brief blip that has perhaps served to obscure what is really happening with the real economy.

 

All I can say is that I hope I am wrong here, and that the Fed is on course, but I think as each week passes the likelihood is that it is falling rapidly behind the curve on this recovery, and probably more worrisome, as the long bond yields show, that the bond markets have bought the Fed's arguments, lock, stock and barrel.