McCrone report: page 1-11

                                                                          Mr Reid
SCOTTISH ECONOMIC PLANNING DEPARTMENT
New St Andrew’s House
St.James Centre, Edinburgh, EH13TA
Telephone 031-556 840. ext, 4017

 

J Garlcik Esq
Cabinet Office
Great George Street
London SW1

23 April 1975

At the meeting which you held last week on various aspects of North Sea oil
and devolution I suggested that I might send in the attached paper in the hope
that it would serve as a starting point for any assessment the Unit may wish to
carry out on the economics of Scottish Independence.

The Paper was written over a year ago in the weeks immediately before the
February 1974 Election. This will be particularly apparent of page 5 where, of
course, the Ministerial pronouncements referred to relate to the Conservative
Government. I have not attempted to update any of the figures, since although
there would be differences these do not seem to me to be such as to alter the
argument.

As you will realise, the debate on Scottish nationalism has been founded to a
surprising extent on economic arguments ad the purpose of this paper was to
examine how far this was affected by North Sea Oil. The first part goes
through most of the usual arguments which have been used against the
Nationalists in the past with fairly convincing effect; the second part sets out
the sort of economic strategy which an SNP Government might try to follow
indicating both the dangers and the possibilities. As I said at the meeting, one
can reach almost any conclusion depending upon the assumptions that are
made about tariffs, a common currency, a Scottish Government’s spending
priorities and its success in controlling inflation. My paper may give an SNP
Government the benefit of too many doubts, but I was anxious to see whether
a credible economic strategy could be put together which would appear to be
more convincing in terms of solving Scotland’s traditional economic problems
than the regional policies of the Unionist Governments have been up until
now. I think the conclusion is that the most convincing way of taking the wind
out of the SNP’s sails is by demonstrating that we now have policies which
can make major in-roads into these problems.

When my paper was written it was classified “secret” and given only a most
restricted circulation in the Scottish Office because of the extreme sensitivity
of the subject. I am copying it now to Leo Pliatzky, Dick Ross, Jim Hamilton,
John Liverman and Stuart Scott Whyte.
R G L McCrone

SECRET

THE ECONOMICS OF NATIONALISM RE-EXAMINED
It is commonplace that the discovery of North Sea oil and entry to the EEC
are factors of major economic significance for Scotland. Already both issues,
especially the former, feature widely in the SNP’s election material. The
purpose of this paper is to reassess the economic arguments for an
independent Scotland in the light of these developments, especially the
discovery of oil. It will be shown that the whole framework within which the
economic implications of nationalism were argued has indeed been altered.
The importance of this is probably greater than is recognised at present by the
majority of the public and it may well be, therefore, that the discovery of North
Sea oil will come to be seen as something of a watershed in Scotland’s
economic and political life.

The case for Scottish nationalism is, of course, very much more than an
economic issue. This paper makes no attempt to examine the wider
questions. Suffice it to say that Scottish nationalism has been much more
concerned with economic prosperity than nationalist movements in other
countries. Unlike Wales there is no great cultural movement attaching to the
preservation of a language. The main cause of discontent is the country’s
unsatisfactory economic performance over the last half century, especially the
persistent unemployment and net emigration above all in the West of
Scotland. Poor social and environmental conditions, especially in and around
the city of Glasgow, accompany this outdated economic framework and are
as much a source discontent. Despite regional policy and the efforts of
planners, these problems have not been overcome, nor do they look as if they
will be in the foreseeable future. The SNP have therefore based their
campaign on the assertion that Scotland would be economically better off
independent; and it is for this reason that budgetary estimates have always
featured so large in the controversy. Yet in spite of Scotland’s undoubtedly
poor economic performance the SNP case until recently lack credibility. Most
people regarded both their statistics and arguments suspect, and they
continued to believe that Scotland derived more economic advantage than
disadvantage from the Union. The importance of North Sea oil is that it raises
just this issue in a more acute form than at any other time since the Act of
Union was passed.

[PAGE1]
The Case Against Nationalism
The traditional economic case against nationalism has always been that a
politically independent Scotland would be unable to gain sufficient economic
sovereignty to solve her problems successfully. This is partly a question of the
scale of the Scottish economy, but more of the extent to which it has become
integrated with that of the rest of the UK over the last 270 years.

Scotland needs a faster rate of economic growth than wither she or the UK
has had in recent years if she is to absorb her excess labour resources and
thereby cut down both unemployment and migration, There are three principal
way in which an independent Government might seek to bring this about. First
it could seek to foster and protect Scottish industry by means of tariffs and
import controls. But such measures would risk retaliation from England which,
given Scotland’s close trade ties with England, could cause damage far in
excess of any benefit that may be hoped for. Such policies would also be
incompatible with continued membership of the EEC and withdrawal,
especially with England, Wales ad Ireland remaining members, would clearly
have very damaging consequences.

Secondly, fiscal policies might be used to give especially large benefits to new
industrial investment or tax relief and subsidies to existing industry. This might
involve the imposition of a tax frontier at the border, as still exists between
most EEC countries, but this need not to make it impractical. Such policies
have been used with considerable success by the Irish Republic since the
mid-1950s. The main disadvantage is that England would probably feel
obliged to match the Scottish measures with equivalent in grants or tax
allowances for industry in English and Welsh Development Areas. Up to now
England has always been in a position financially where, if she wished, she
could have more than matched any measures which a Scottish Government
would be able to afford.

It is here that the budgetary position of a Scottish Government becomes
important. Various studies, notably the Treasury’s Scottish Budget of 1967/68
and the work of the Kilbrandon Commission have shown that public
expenditure per head in Scotland is generally above the UK average, whereas
public revenue is Scotland is slightly lower, largely because Scottish incomes
are below the UK average. The result is that budgetary estimates for Scotland
show a proportionately larger borrowing requirement than for the UK as a
whole. His position is confirmed in the most recent estimate of Scotland’s
budgetary

[PAGE2]
position carried out by the Economic and Statistics Unit of SEPD for 1971/72.
This shows a Scottish current account surplus of £24m. but a net borrowing
requirement of £447m. overall.

There are, of course, various ways in which this could be tackled. In the first
place it is not necessary to balance the budget. To finance loans and various
items of capital investment, particularly those which yield a return by
borrowing is quite reasonable; other items too may be covered by borrowing
form time to time particularly if an expansionary budget is necessary to
generate a higher level of economic activity in the economy. For these various
reasons the United Kingdom budget normally involves a net borrowing
requirement and whilst this will normally be fairly small this is not always so; in
the present year, for example, the borrowing requirement reached the record
figure of £4,000m.

If allowance is made for the capital items that it would normally be reasonable
to finance by loan, this would still lave a Scottish deficit of over £200m., a very
similar figure in 1971/72 to what it was in 1967/68. Whilst such a figure could
be covered if it arose only exceptionally, it could not be tolerated as a regular
feature of the budget. It would involve a steadily increasing Scottish debt and
it would have serious implications both for interest rates and monetary policy,
unless a substantial part of it could be financed from abroad. A Scottish
Government would therefore have to take steps to reduce the deficit either by
raising taxes or cutting expenditure. Such measures are perfectly possible,
and on the scale necessary, need not provoke a intolerable situation,
especially if defence was one of the items cut; but they would create a
background of acute budgetary stringency against which it is hard to see it
being possible to provide a major fiscal stimulus to encourage economic
expansion.

The third possible course of action would be to devalue the Scottish currency.
This would stimulate economic activity by increasing the demand for exports
and making Scottish goods more competitive against imports in their home
market. In many respects devaluation would be the obvious measure for an
economy in Scotland’s condition with persistent unemployment, a budgetary
deficit and probably a serious adverse balance on the balance of payments.
Indeed, if the later was persistent, it might be that devaluation would be
inescapable.

Exchange rate adjustment is, of course, the ultimate and most effective
weapon by which an economically sovereign state maintains approximately
full employment while at the same time avoiding balance of payments
disequilibrium. Indeed, if Scotland could have devalued by a good thumping 2
percent and made the

[PAGE3]
adjustment effective in terms of costs, this would be by far the best way of
solving Scotland’s economic problems of the last two decades. It has been
argued that the ‘regional problem’ only arises because exchange rate
adjustment, the normal way of dealing with disequilibria between countries, is
not possible between regions.

However, the economic case against Scottish nationalism has always at
bottom come down to the proposition that an independent Scotland would not
find it possible to carry out an effective devaluation. To be effective,
devaluation involves a country in making a cut in its real living standards at
least until such time as production is able to catch up. But the Scottish labour
market is so closely linked with that of the rest of the UK that it is hard to see
how real earnings could be adjusted downwards without giving rise to the
most serious difficulties. For such a small country heavily dependent of
international trade, devaluation would, of course, have serious inflationary
consequences, since all imports would rise in price. Trade Unions are to a
large extent on a Great Britain basis and it is hard to see them accepting a
deliberate attempt to cut real wages in Scotland compared with England
whatever the reason for it may be. Furthermore, even with independence,
freedom of labour movement between England and Scotland would be likely
to continue, a common language and two and a half centuries of free
movement make this easy. Changes in real wage levels would therefore be
likely to be reflected in migration figures and could lead to a shortage of
certain types of skilled labour in Scotland even while a surplus among the less
mobile unskilled persisted.

It is for these reasons that many economists have in the past concluded that
Scotland, if she were independent, would probably be unable to devalue
effectively against the rest of the United Kingdom. Lacking this ultimate
weapon of economic sovereignty and limited by the budgetary situation in the
use she could make of fiscal policy, it did not seem that political independence
would give Scotland sufficient economic sovereignty to enable her to tackle
her economic problems successfully, At the same time, whatever the
constitutional set-up, the Scottish economy would remain closely integrated
with that of the rest of the UK and would be greatly affected by policy
decisions taken in London, though as an independent state her ability to
influence those decisions would be greatly reduced.

The Implications of North Sea Oil
The analysis in the last section is based on the situation as it appeared before
the discovery of North Sea oil. Even after its discovery the full significance of

[PAGE4]
North Sea oil was not immediately apparent and it still remains in large
measure disguised from the Scottish public by the DTI’s failure to make
provision for a proper Government return when the fourth round of licences
was issued. So far all that Minister have said is that they expect North Sea oil
to be yielding 70-100m. tons of oil per annum by 1980 and that on that basis
the Government revenue from rent and royalties from the whole of the
Continental Shelf including the gas fields in the southern sector may be of the
order of £100m. per annum at that time. It has been explained that this
estimate does not include the yield from ordinary taxation on the oil
companies and it has been stated that licensing policy is currently under
review but the significance of this has probably not been fully appreciated by
the public.

The SNP countered these figures by claiming that North Sea oil should by
1980 be yielding a Government revenue of approximately £800m. and have
charged the Government with giving Scottish oil away to the international
companies ridiculously cheap. Up to now much of the Scottish public may
have regarded the SNP figures as pretty wild and they have been publicly
condemned as such by Ministers. But authoritative support for the charge that
the Government has failed to do a satisfactory bargain with the companies is
provided in the criticisms of the Public Accounts Committee which so far
remain unanswered. The example of Norwegian policy on Government
revenue from oil likewise shows up the failure of British.

The Government’s reveiw of licensing policy has been in progress since the
early summer of 1973. This has confirmed the total inadequacy of
arrangements to secure Government revenue and shows that some of the
most attractive measures to put this right would involve breaking the terms on
which the licences were given. It is partly for this reason that the Government
has so far failed to take a decision, the choice lying between carried interest
(ie state participation), which would provide the biggest revenue and also give
some power of control but would go back on the terms of the licences, and
excess revenue tax, from which the return in 1980 would be some £200m.
less but would be defensible in international law. The DTI estimates of last
summer showed that total Government revenue following adoption of these
measures would have been between £800m. and £1,200m. a year in 1980
depending on the system used and the prices prevailing in 1980; today,
following the huge increase in international oil prices of recent months the
corresponding figures are in the range of £1,500m. to over £3,000m. Thus, all
that is wrong now with the SNP estimate is that it is far too low; there is a
prospect of Government oil revenues

[PAGE5]
in 1980 which could greatly exceed the present Government revenue in
Scotland from all sources and could even be comparable in size to the whole
of the Scottish national income in 1970.

As well as the gain to the Government Revenue, North Sea oil will of course
make a massive contribution to the balance of payments; indeed these two
aspects are closely linked. At present world prices the expected output of
100m. tons of oil in 1980 is worth approximately £3,000m.; assuming price
rises from the present £33 a ton to £51 a ton as in the Government revenue
calculations the value could be as high as $5,000m. Part of this will, of course,
be repatriated by the international companies in the form of profits distributed
to their shareholders or reinvested in projects in other areas. The balance of
payments gain to Scotland would therefore depend critically on the amount of
Government revenue secured from the profits. Indeed, since none of the
major companies operating in the North Sea are predominantly Scottish
owned, the Government revenue would be the major element, apart from the
expenditure of the companies on goods and services produced in Scotland,
which would accrue from the value of oil produced as a balance of payments
gain. Thus assuming measures which would yield Government revenue of
the scale referred to in previous paragraphs, plus some additional revenue to
shareholders in Scotland and to suppliers of equipment, then the net balance
of payments gain might be expected to lie very approximately in the range of
£2,000m. to £3,500m. a year, depending on prices and the share of the
Government ‘take’.

It is not possible to compare these figures with an accurate estimate of
Scotland’s present balance of payments position. From the state of Scotland’s
economy one would expect a balance of payments deficit on current account
and a rough comparison of income and expenditure estimates for GDP
suggest that this could be of the order of £300m. a year in 1970/71. Plainly
this is a most unreliable figure and it will vary from year to year, but it is
probably sufficient to suggest the orders of magnitude. What is quite clear is
that the balance of payments gain from North Sea oil would easily swamp the
existing deficit whatever its size and transform Scotland into a country with a
substantial and chronic surplus.

All the above figures are, of course, based on the estimated output of 100m.
tons of oil in 1980. This was the DTI’s revised estimate in the early summer of
1973.

[PAGE6]
Already it is beginning to look as if these estimates may be too conservative.
Recent finds and the plans of companies appear to indicate that the Shetland
basin may prove very productive indeed. Zetland County Council’s
consultants worked on the assumption that 70m. tons a year might actually be
piped ashore in the county. It is now known that Shell expect to land 50m.
tons a year through their own pipe alone and pipelines may also be expected
from Total’s Alwyn field, Conoco’s Hutton and the recent BP and Burmah
finds. In addition to this there are, of course, substantial finds further south,
particularly BP’s Forties field and Occidental’s Piner. Whether or not this, plus
any new finds that are made, result in the 1980 estimate of 100m. tons being
exceeded largely depends on how quickly newly discovered fields are brought
into production, but it does now seem extremely likely that production during
the 1980s will use well above 100m. tons a year with consequent increases in
revenue and gain to the balance of payments.

Can one be certain that the oil is without doubt a Scottish asset or, even if it
is, that these substantial revenues and balance of payments advantages
would indeed accrue to an independent Scotland? Clearly these questions
raise complicated issues in international law which could, if allowed, occupy
the legal profession for many years. Two possible lines of argument may be
expected: either that Scotland should pay England some compensation for
appropriating the most productive part of the Continental Shelf, or that the
whole shelf should be regarded as the common property of the nations of the
former United Kingdom with revenue distributed in accordance with some
population based formula irrespective of where oil is discovered. As regards
the first of the arguments, the prospective return from oil revenue would at the
very least be one of the factors taken into account in determining the financial
settlement between the two countries when they become independent. To
argue the second would be directly counter to the line that the UK
Government has taken with the EEC, that the resources of the Continental
Shelf are as much a national asset as are those on land, like coal mines, and
that there is therefore no question of the Europeanisation of North Sea oil.
Disputes on these matters might well occasion much bitterness between the
two countries, but it is hard to see any conclusion other than to allow Scotland
to have that part of the Continental Shelf which would have been hers if she
had been independent all along.

There might be some argument about where the boundary between English
and Scottish waters would lie. At present this is considered to be along the
line of latitude which lies just north of Berwick on Tweed, and it might perhaps
be held that it should run NE/SW as an extension of the Border. This could
have the effect of transferring the small oilfields in the south, Auk and Argyll,
to the English sector, but would not affect the main finds.

[PAGE7]
It must be concluded therefore that large revenues and balance of payments
gains would indeed accrue to a Scottish Government in the event of
independence provided that steps were taken either by carried interest or by
taxation to secure the Government ‘take’. Undoubtedly this would banish any
anxieties the Government might have had about its budgetary position or its
balance of payments. The country would tend to be in chronic surplus to a
quite embarrassing degree and its currency would become the hardest in
Europe, with the exception perhaps of the Norwegian kroner. Just as deposed
monarchs and African leaders have in the past used the Swiss franc as a
haven of security, so nowwould the Scottish pound be seen as a good hedge
against inflation and devaluation and the Scottish banks could expect to find
themselves inundated with a speculative inflow of foreign funds.

[PAGE8]
II
A Policy for Development

The situation described in the first part of this paper is indeed an astounding
reversal of the problems which are usually considered in a Scottish or British
context. But it could nonetheless give rise to some serious difficulties and
would require careful handling if Scotland was really to derive maximum
benefit from it. It is, of course, perfectly possible that these difficulties would
not be overcome and that an independent Scotland despite its wealth would
continue to have an unsatisfactory economic performance. It takes more than
money to eliminate the traditional problems of the Scottish economy and
nationalist movements, dependent as they are on strong emotional pressures,
have not always been notable for their economic realism. In this respect the
example of Ireland’s poor economic performance between 1922 and 1956
comes immediately to mind and the SNP is already showing signs of making
promises which could be an embarrassment to its economic management.
Nevertheless it is obvious that the surpluses from North Sea oil would open
up new opportunities for a nationalist Government. The purpose of this
second part of the paper is therefore to consider in very brief outline some of
the policies a nationalist Government could follow to try to bring about the
development and prosperity of the country as a whole.

Scotland’s central economic problem is to secure a faster rate of economic
growth so that she can raise income levels and absorb the excess labour
which presently appears as high unemployment and emigration. As has been
explained, this is a situation which would normally point to devaluation as a
possible remedy. North Sea oil, however, by giving the country a chronic
balance of payments surplus, would rule out any possibility of devaluation.
Indeed, it is hard to see how an upward valuation of the currency could be
avoided. Obviously this pressure should be resisted as far as possible; but
unless there was a remarkable change in the strength of sterling, it must be
expected that the Scots pound would rise in relation to it fairly soon after
independence, especially if the latter continues its downward slide. A
revaluation would give rise to none of the difficulties which were argued earlier
to apply to a Scottish devaluation. Since the effect would be to reduce prices
and raise incomes there would not be the same resistance to making it
effective in Scotland. An exchange rate of £1 Scots to 120p sterling within two
years of independence therefore seems quite probable.
This exchange rate movement would improve Scottish real incomes; imports
would all become cheaper, and GDP per head in Scotland, which would
include the value of the oil produced, would rise smartly. The gap between
Scottish income per head and English would probably soon be eliminated and
might well be reversed. The danger is that with a rising currency Scotland’s
traditional economy would find it more andmore difficult to

[PAGE9]
compete; manufactured exports would be priced out of foreign markets and
imports would become highly competitive at home; tourist would find that the
rate of exchange made Scotland a very expensive country for holidays; and
Scottish farmers would find that the EEC’s Common Agricultural Policy gave
them a much less satisfactory level of support than expected. Thus there
would be grave risk that the economy would be driven more and more to
depend on the oil industry and other activities would tend to wither. But while
oil would give Scotland a good income, it could never be an adequate source
of employment with the rest of the economy in decline. Scotland, therefore,
could face the danger of prosperity coupled with continuing or even worsening
unemployment and emigration.

To counteract this situation it would be essential to try to keep the surpluses
on the balance of payments down and thereby reduce the upward pressure
on the exchange rate. This could involve extensive lending abroad, whether to
England, the EEC or under-developed countries. Such lending could well be
in Scotland’s interest rather than face the prospect of an intolerably high
exchange rate; it might also do much to help cement relations with other EEC
countries and, coupled with the supplies of oil for export, would make
Scotland a highly desirable member of EEC with a strong bargaining position.
The first priority, however, would be to spend the surpluses as far as possible
in developing Scotland’s domestic economy and providing a modern
infrastructure. The following paragraphs suggest how this might be done.

a. Manufacturing Industry
Output per head in most sectors of Scottish industry is well below
European levels. This is largely because the British economy has
invested much less than other European countries over the last 25
years. A substantial increase in manufacturing investment is
therefore necessary if this is to be put right. Only then will Scottish
industry be able to compete effectively with other members of EEC
at anything other than low exchange rates.

Part of the reason for the low investment in Scotland in the past has
been the persistence of ‘stop-go’ in the UK economy. Every time
investment has begun to rise satisfactorily, as it was doing in 1973,
the emergence of a balance of payments deficit has forced the
Government to take strong

 

[PAGE10]
deflationary measures with the result that the investment boom has petered
out again. Scotland made good progress in 1973, but ideally from her point of
view the 5 per cent growth rate needed to go on for another couple of years.
As an independent state, Scotland’s balance of payments position would
enable her to break out of the ‘stop-go’ cycle and a sustained rate of growth
could be planned on the basis that it could be carried on for at least a decade.
The strength of the currency coupled with the budgetary surplus would help to
keep interest rates down and there would be no need for sudden increases in
taxation or massive cuts in public expenditure. Admittedly, since Scotland is
so closely tied to the English market, her economy would continue to be
affected by measures taken in London, but this effect would diminish the more
Scotland expands trade with other EEC countries. Furthermore, it would be
quite proper for a Scottish Government to take countervailing measures to
stimulate the Scottish economy at times when England was going through a
recession. Such measures would help to keep Scottish output up and would
help the English economy by reducing the Scottish balance of payments
surplus. It can be expected therefore that the prospect of sustained expansion
and an end to ‘stop-go’ would do more than anything else could both to raise
investment in domestic industry and to encourage foreign investment to come
to Scotland.

However, this expansionary macro-economic policy would need to be backed
up by firm regional policy measures. The position in West Central Scotland
has deteriorated vis-à-vis the rest of Scotland over the last decade and this is
likely to be even more accentuated by North Sea oil developments.
Furthermore, as an independent state, it would seem to be quite inappropriate
for Scotland to regard the whole of the territory as subject for regional policy.
Something along the lines of the following package of measures therefore
seems to be most appropriate:-

i. For Scotland as a whole the Regional Development Grant would be
abolished, but to stimulate investment Corporation Tax would either
be abolished or reduced to a purely nominal rate. This would have
the effect of more or less removing the tax from industry’s retained
profits while leaving distributed profits taxed roughly as they are at
present. As a national fiscal policy

 

[PAGE11]

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