The misplaced economics of Scottish independence

I had an interesting discussion today on the economics of Scottish independence, and I recalled this piece by Evan Davis:

[...] It is interesting to ask what economic cases can be built for or against an independent Scotland. Indeed, lots of economists are taking to the newspapers and airwaves to offer a view.

Here's mine. It starts with the basic premise that Scotland has two things that England does not. The first is a disproportionate level of UK funded public spending. The second is oil, the revenues of which are taken by the UK government.

If Scotland were independent, it could expect to lose the UK funded public spending; but it could expect to gain the oil money. In the short term, that's the fiscal choice Scotland would be making if it decided to leave the UK and go it alone.

As it happens, the choice is a fairly balanced one at the moment. The oil money Westminster takes, more or less pays for the "extra" public spending Scotland enjoys.

Now, given the uncertainties of this debate, that's about all the data you need to make a short term assessment of Scotland's "viability" as an independent nation. If Scotland had been independent last year, and had stuck to the same spending policies, it would have had a government whose fiscal position was not that different to that of the UK.

A lot of debate has been stirred by this however. You can read about the competing claims in my postscript below. The Scottish Executive claims about Scotland's deficit make it sound unviable; the SNP claims make it sound as though Scotland is in surplus. The truth I think lies in between. On my calculation for last year, I think Scotland would have had a deficit of £3.5 billion, which would have been manageable.

However, does all this statistical banter matter? Probably not much. The short term is not the best horizon over which one should assess Scotland's viability.

The choice to take money out of the North Sea rather than out of the Westminister Parliament would have long term implications. And one negative implication in particular, is that an independent Scotland would be very dependent on oil.

Oil would be vital to sustaining the current level of Scottish public spending, accounting for a fifth of government revenue, and about the same proportion of national income. And yet, at some stage, the oil will run out or diminish. Or the price will fall. And then what?

The decision to go independent then, involves a gamble: that Scotland could re-develop itself better as a separate economy than as part of the UK; and that it could do so before the huge oil economy faded out of its current significance.

It's a gamble because we don't know what will happen to oil, and nor do we know how successful Scotland will be at reinvigorating its economy. It could go right, as it has for Ireland in recent years. Or it could go wrong, as it did for Ireland in the first few decades of its history.

However, there is one other implication of independence. And this is perhaps the most important, and the least predictable. Would it move the political centre of gravity in Scotland? For London-based journalists, it is striking just how far left of England, Scotland's politics lies. How would independence affect that?

There is something bothering me about this analysis, and Evan Davis's post is by no means an isolated example. It's not that Scottish independence is not, or should not be seen as, an economic issue: everything is an economic issue, including nationhood.

What strikes me as odd is the timeframe of the analysis. Is the government's fiscal position over the next five years really such an important element of national identity? Do you really want your grandkids to say their country went independent for a handful of pounds per capita?

Maybe my approach to discounting the future is too extreme, and I should be putting more weight on the present. But in a similar manner to the Stern Review on the environment, I believe the right timeframe for assessing nationhood should never be the nations' equivalent of next weekend.

If your wife's decision on whether to leave you or not hinges on how her car insurance premium will be affected over the next five years, you would not be unreasonable to think something's not quite right.

Increases in wage inequality and the fall of unions: chicken and egg?

A few posts ago, I promised I would say more on the issue of unions and wage inequality.

Many economists suggest that the declining fortunes of unions are the main driver behind the increase in income inequality over the past few decades. While I agree that decreases in union membership and increases in wage inequality go hand-in-hand, I believe the standard narrative is somewhat misguided when it comes to causality. Rather than declining unions leading to increased wage inequality, it is the increasing variance of individual worker productivity that lies behind both.

In a pattern familiar to union watchers, the union will usually stand for wage equality rather than 'meritocratic' pay. It is easy to see why this is so: unions are democratic institutions. As is the case with elected governments, they will redistribute from the productive (potentially high-wage) to the unproductive (potentially low-wage) workers in order to please the median voting member. In the presence of a dominant union, all workers are awarded the wage that corresponds to the average productivity of all members.

In contrast to the state, however, membership of a union is not compulsory (at least in most cases). Why do high-productivity individuals choose to join the union then? To understand this, it is important to grasp a subtle point: even if a worker has higher productive potential than average and would thus be paid more in the absence of collective wage bargaining, what matters to the employer is marginal productivity - the product this additional worker will generate given the existence of all other workers.

Marginal productivity tends to fall as the number of workers increases. As a result, a large, unionised workforce will in many cases mean that the marginal productivity of the high-ability worker may actually be below average productivity. When that is the case, the high ability worker has an incentive to join the union, as the average wage represents the best attainable outcome.

When the differences in individual workers' productivity are relatively small, joining the union is the most attractive option for low and high ability individuals alike. However, as the nature of jobs changes and the productivity potential of some workers increases far above that of the others, opting for the average productivity wage offered by the union is no longer the most appealing proposition for some very productive workers - their marginal productivity is above average, and they can command a higher wage by choosing to go it alone.

As more and more workers break away from the pact in terms of individual productive potential, the average productivity of the union's membership falls; and the existence of a large pool of high-ability non-unionised workers restrict its ability both to redistribute from high to low ability workers as well as halt its own demise. At the equilibrium, the only sectors where unions are dominant are those where workers are of relatively uniform ability: for example, industries employing the low-skilled.

The fall in the power of unions was not a random event that then led to the increase in wage inequality we observe. This development should be attributed to the changing nature of production and the subsequent increase in potential wage inequality: unions were merely a short-run obstacle to achieving that new equilibrium.

Voting weights reform: Think at the margin

The Economist's Certain Ideas of Europe blog weighs on the recent Polish proposal:

[...] Poland has grabbed everyone's attention by calling for a change in voting rules, so that voting weights in the EU council of ministers are based on a square root of each nation's population. This is a system that Poland considers much more equitable than the one on offer in the constitution, which says that votes pass when 55% of EU members, representing 65% of the EU's population, can agree.

Economists and game theorists have been busy weighing in on both sides. [...] All the studies of combinatorics that currently fill my email inbox fail because, early on, they concede that in the interests of clarity they assume that coalitions consist of nations taking decisions randomly. But they don't. Luxembourg and Belgium always vote for more European integration. The Nordics vote with Britain and the Netherlands on free trade things. Ireland has low taxes so votes with Britain against tax harmonisation, but has a powerful farms lobby so votes with France to preserve farm subsidies.

The EU is not about mathematics, because EU voting is not about numbers, it is about politics. This may sound like special pleading, given that the author of this posting is a political reporter and not a mathematician. But any analysis that looks at this on the basis of numbers is entirely missing the point.

Well, that's not true. The quoted piece does a very good job of putting the proposed reform into perspective: De jure power in the Council of Ministers is a small contributor to, and poor proxy for, de facto power. This, however, is not the same as saying voting weight reform is irrelevant and that 'the EU is not about mathematics, it is about politics' or that 'any analysis on the basis of numbers is entirely missing the point'. As is the case with the evaluation of any reform, what matters is how the balance of power changes at the margin.

While the UK will not lose 30 per cent of its ability to block legislation as the Spectator claims, it is equally wrong to say that Britain won't be worse off if the Polish proposal is accepted. Given the absence of a suitable theoretical framework and good data on the determinants of de facto power in the Council of Ministers, it is difficult to establish the magnitude of this loss; but this doesn't mean the mathematical approach is redundant.

For those interested in the 'mathematics' of square root voting weights, Vox EU offers an excellent treatment - a must read for budding game theorists and political scientists.

Postscript: The Certain Ideas of Europe blogger also mentions the fact that many countries tend to always vote the same way on given issues. This is a call for the analyst to dig deeper and assess how reform would affect the de jure power of any given country taking into account its effect on the power of its allies. Again, this is not an argument against mathematical analysis; it is a simple re-statement of the perils of simplistic approaches.

This made me laugh

A maths teacher asked a boy a question.
"What is two plus two?"
"Four" the boy replied.
"Very good" said the teacher.
"What do you mean, good?" the boy snapped. "It's perfect!"

From the ASI blog.

Unemployment benefits around the world, narrowly defined

Via Greg Mankiw:


Be very careful how you interpret this graph. In fact, it's better to try to forget it immediately and resist the urge to draw any inferences whatsoever.

The level of unemployment benefit affects three important variables: the government's fiscal position, incentives to work and hardship endured by the unemployed.

On the first of these, it is clear that the data reveal very little, at least in the absence of information on unemployment and a note on how they were derived. (Is 'averaged across a range of wages, family types and lengths of unemployment' self-explanatory to you? It's not to me)

With regards to incentives to work and hardship endured by the unemployed, the figures again reveal hardly anything. Greece is near the top of the table above, yet it enjoys strong family bonds - social norms dictate that the unemployed are handsomely supported. Also, how much of a loss in consumption does unemployment in each different country entails? If high quality health care, education and entertainment is provided by the state free of charge to both unemployed and employed, is the loss of employment income so important? For that matter, does the figure refer to pre- or after-tax pay?

No piece of information allows us to draw any inference without first assuming some factors or relationships remain constant. The challenge when faced with data of any type is to decide whether any such assumptions can reasonably be made: in the case of the figure above, the answer is no.

Of course, numerous other seemingly relevant facts and statistics are cited every day both in print and in conversation. My advice? Release a sigh of despair, mumble some French, and move on.

Friday Special 7

The difference between marketing, advertising and PR, pulling edition

Ever wondered what's the most popular youtube video of all time?

That's taking it a bit too far

A taste of TED (video)

Mickey stayed in Albania

US town set to ban saggy trousers

And finally, please don't watch this if you don't want to be offended. Strong language and pure, unadulterated nastiness. Sarah Silverman's opening monologue at the MTV 2007 Movie Awards

Breaking up is good for your savings

Via the excellent Organizations and Markets:

SEOUL (AP) — A South Korean bank is offering to help heartbroken soldiers dumped by girlfriends while away on mandatory military service by providing special interest rates for stilted troops.

Soldiers who can show letters or e-mail proving their break-up to a bank clerk can receive a new deposit plan with better rates and waived service fees.

A friend challenges me to explain this using standard economic tools, i.e. without retorting to 'the world has gone mad' class of explanations.

I'll try to rise to the challenge. Of course, there is always the possibility the bank is making a mistake and will suffer as a result. That said, I can think of at least four ways in which offering lower interest rates to heartbroken conscripts may actually be good for profits:

1. Dumped soldiers may indeed represent better credit risks bacause they are less likely to splash out on expensive gifts to their girlfriends.

2. The 'good-will' and publicity effects compensate for the suboptimal pricing of credit risk by drawing more customers to the bank.

3. To the extent that shareholders' utility arguments include both a private income and a social welfare element, 'socially responsible' undertakings can lead to increased demand in the bank's shares, and the company enjoying a lower cost of capital.

4. Assuming switching banks is costly, consumers optimise their choice of bank intertemporally. Choosing this particular bank may thus be a form of insurance against being dumped in the future.

Am I half-convincing?

Addendum: A reader alerts me that I am actually talking about lower interest rates for loans, while the bank is offering higher rates for deposits (this post was initially titled 'Breaking up is good for your mortgage').

Let me try and rescue this. Explanations #2 and #3 still stand. #1 has to be adapted to say heart-broken soldiers are more reliable savers (e.g. they are less likely to make large, sudden withdrawals or take out unathorised overdrafts. #4 is only relevant to the extent the bank establishes a reputation for offering premium rates to those suffering misfortunes.

Updated analysis aside, I'm still a bit embarassed about my initial attempt to explain the 5th of the last 3 recessions. There's a lesson here: Alcohol and econ-blogging should not mix.