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The rules of the new game

17 September 2014 By Edward Hadas

Adam Smith, one of the leading figures of the 18th century Scottish intellectual enlightenment, liked free markets and restrained governments. The 21st century campaigns for and against a Scottish political liberation show that governments have acquired an economic importance which Smith could hardly have imagined.

If the government’s economic role was as limited as Smith would have liked, the debate preceding the Sept. 18 independence referendum would mostly have been about national identity and the advantages and difficulties of becoming a small country in a big world. The economy would hardly be an issue, since only the most rabid Scottish nationalist would accuse the English of cruelty in that domain.

In fact, though, the purely political issues seem less important than the question of what might be called political economy: would a Scottish government with full regulatory, fiscal and monetary control make the nation richer? The answers differ, of course, but there is a shared assumption that the government is right at the centre of the economy.

In a way, that is quite right. The remit of modern governments runs through the entire economy. They regulate, adjudicate and motivate. They are the largest employers and purchasers in any country. They run complicated welfare states. They build infrastructure, protect private property and make key investments. Their deficits help keep the economy on an even keel.

For Scotland, however, most of that hardly matters. This referendum is politically momentous, but economically nothing like the 1990 East German parliamentary election, in which voters chose to abandon the communist model for the West German social market. The Scottish nationalists are not planning any radical alterations to a British system which works pretty well.

In addition, any new Scottish government would be constrained by the limited amount of economic sovereignty available. These days, no nation is an island (although North Korea comes close). As Adam Smith would have hoped, there is extensive cross-border traffic in goods, services, capital, people and ideas. The demands of treaties and trading partners restrict the freedom of all national governments.

Big countries have more freedom than small ones, because the United States and China, with their GDPs of over $16 trillion, can make more plausible threats than Malaysia or Scotland, with GDP of about $300 billion. The best way for Edinburgh to protect the national self-interest will be to sacrifice some of it, to please powerful allies.

All in all, a new Scottish government should not find most parts of economic management challenging. It would simply have to follow best global practice. Rich countries have learned to cope fairly well with pretty much every type of economic challenge: natural disasters, revolutionary technologies, demographic shifts, even the tensions between rich and poor.

There is one major exception: finance. Governments frequently stumble in matters of money. Scotland is unlikely to be an exception.

The rapid spread of the financial crisis almost six years ago, and the painfully slow recovery since then, are unfortunately typical of the official inability to keep the financial sector in control. The litany of failures is a bit surprising, since the authorities have the power to create and destroy money and credit pretty much at will. However, ignorance reigns. Economists cannot agree on how to deal with the most basic issues of money, credit and financial markets.

An independent Scotland would have to find its way alone in this trackless forest. It might be forced into excessive austerity or fall into a bank or currency crisis. But independence would not really be responsible for any missteps. After all, if anyone actually knew how to keep monetary and banking systems safe and sound, there is every reason to think that Edinburgh, renowned for its financial expertise since shortly after Smith’s day, would be able to put that knowledge into action.

As it stands, though, financial uncertainty is by far the best economic reason to reject independence. Even if the authorities in London and Brussels want to lend a helping hand to the new nation – and that is far from a foregone conclusion – Edinburgh would have to win the confidence of a much more fickle group, global financial investors.

These short-sighted profit-seekers can be kept at bay, but only by building up substantial currency reserves and imposing capital controls to limit the flow of funds in and out of the country. The Scottish government would start out too poorly endowed for the first and its desire to join the EU rules out the second.

Although Adam Smith’s ruminations on finance are mostly outdated, he understood a basic truth about the risks that come with this dependence. Consider his comment on the Ayr Bank, which, as Smith scholar David Bholat explains, was a proto-central bank for Scotland. It failed in 1772, crushed by foreign lenders’ high interest rates. In Smith’s words: “In the long run, therefore, the operations of this bank increased the real distress of the country which it meant to relieve.”

 

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