Thursday, 6 February 2014

Breaking up is hard to do

As I predicted earlier, all those repeat TV showings of Braveheart is slowly moving the polls on Scottish independence into ‘just maybe’ territory. OK, that is a bit flippant: as the Economist notes, the best recruiting agent for a Yes vote to independence is not Mel Gibson but George Osborne. Yet the problems that would have to be resolved if the Scottish people vote yes to independence are pretty serious. And the vote itself may depend on how these problems are perceived.

For those not living in these Isles here is the story so far. The prospective Scottish government says it wants to keep sterling by forming a currency union with the remaining UK (rUK). The No (to independence) side (most rUK politicians) suggest that the terms that the rUK would set for establishing a currency union would be pretty onerous for Scotland (see the Eurozone). Indeed they hint that the whole idea of taking on some kind of lender of last resort role for Scotland might be so unappealing that rUK might just say no whatever.

The pro Scottish independence (SNP) side respond that if the rUK takes that line, Scotland might decide not to take on its share of UK government debt. (What its share is remains unclear, and will also be the subject of complex negotiations.) This has apparently created some nervousness among UK debt holders, so the UK Treasury has recently taken the unusual step of saying that if Scotland becomes independent the rUK will guarantee all of the UK’s debt, and not just what it thinks is rUK’s share. Which, if you are in the SNP, might lead you to think that your threat of not taking on any UK debt is credible.

That would be a foolish thing to believe. Suppose negotiations did break down, with rUK refusing to form a currency union with Scotland and Scotland refusing to take on any UK debt. Scotland would then have to decide whether to continue to use sterling, or have its own currency. But equally important, it would also have to start selling Scottish government debt to cover their inevitable government deficit. The interest rate it would have to pay on this borrowing would in all probability be much higher as markets would view its refusal to take on its share of UK debt as a form of default.

However I suspect the situation would be even worse for Scotland, in that the rUK government would simply expropriate a share of Scottish oil tax revenue to compensate for the extra debt interest it had to pay. In the end this comes down to realpolitik, and rUK holds the ultimate cards.

Another argument that the SNP has used is that it is in the rUK government’s interest to have a currency union with Scotland, and so this will keep it at the negotiating table and give the SNP some power. I think Scotland and rUK do meet optimal currency area conditions, so in theory this is true. However Scotland would be negotiating with the current government. The current government has shown, with its attitude to migration and an EU referendum in particular, that short term political interest trumps national economic interest. As a result, the SNP cannot bank on the rUK government pursuing the optimal policy from rUK’s point of view.

Of course all this has a close parallel with debates about the Eurozone. Academic and international policymaking views on the Eurozone typically take one of two directions at the moment: either it was doomed from the start, or it has to move to a fiscal union. (See, for example, Dani Rodrik here.) The SNP position is therefore very difficult, because it wants to move to a currency union without a fiscal union. The Eurozone experience is hardly a good advert for that idea.

Now I have considerable sympathy for the SNP’s position on this, because I see the Eurozone’s failure as a failure of the Eurozone’s particular architecture, and not of the whole idea of a currency only union. One way to put this is that the Eurozone’s problems stem in large part from an initial market misperception about the possibility of individual member government default, together with a (continuing!) misperception by the Eurozone about fiscal policy’s role. However market misperception will not happen again as a result of Greek default. One consequence is that the need for centralised controls of currency union members’ fiscal decisions has decreased following Greek default - there is no longer a free rider problem. (Any fiscal irresponsibility shown by a currency union member will now lead to a larger increase in their debt financing costs than if they had their own currency, for reasons set out by De Grauwe e.g. here.) As a result, a prospective Scotland-rUK currency union can delegate most fiscal decisions to Scotland, and just needs to sort out how the central bank will decide when to offer unconditional support for Scottish debt (its version of OMT), and when to allow default. (See, for example, this post.)

However whether this is true or not is academic from Scotland’s point of view. It has to negotiate with the current UK government, which for various reasons will not see things in the way I presented them in the previous paragraph. To be fair, that is partly because my view is a minority view, and the governor of the Bank of England recently (pdf) put forward the more normal line that a currency union needs more centralised fiscal control. But it is also because a yes to independence vote will be a huge personal defeat for the current UK government, and they will want to do their utmost to demonstrate that the people of Scotland have made a big mistake. And as I said earlier, they will have the power to do that, whether it is in the economic interests of rUK or not.


So I think it is a reasonable assumption that the SNP’s preferred solution of a Scotland-rUK currency union will result in very tight aggregate controls on what Scottish fiscal policy can do. Nevertheless credit risk will remain, so Scotland will end up paying more to service their share of UK debt than the rUK. The National Institute estimate (pdf) that under a currency union Scottish borrowing costs could be between 0.75 and 1.5 percentage points above UK borrowing costs. So if the Scottish people think that voting for independence will bring an end to fiscal austerity, I think they would be making a mistake.

15 comments:

  1. It still looks overwhelmingly likely that Scotland will vote to remain in the UK and continue the slow process of making the Tory Party unelectable.

    Were Scotland to secede, do you think it will take Northern Ireland with it?

    I say that puckishly, as the unravelling of the UK will be most unpleasant politically.

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  2. Perhaps you underestimate the traction that business will have on the rUK government. Refusal to enter a currency union will add significantly to the costs of rUK companies who want to export to Scotland, who are the second biggest rUK export market. They may not be very pleased if Westminster does that.

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    1. The "it's in rUK's interest to have a currency union" argument is a bit besides the point in my view as the real issue is what they'd ask in return for a currency union. A currency union without a lender of last resort would be the worst of all worlds. As would a currency union in which they insist on some draconian distribution of the national debt.

      The debate seems to conflate something being in a country's wider interest with having actual power over negotiations - it's a bit like saying that because Tesco has a mutual interest in me buying my lunch there I have a good chance of haggling on the price of my sandwich (the difference in volume of trade means Scotland will always get the raw end of the deal).

      I also think there's a democratic argument that gets overlooked in all of this. While Germany might dominate the Eurozone, the other states at least have formal representation in the decision-making process. Our ill-defined currency union would have Scotland tied to a single country (one obsessed with austerity no less) without any formal representation in joint decision-making. We'd be sacrificing our representation in Westminster yet acknowledging that it would still make key decisions over our economy. That's simply creating one democratic deficit to solve another, and there's certainly no advantage in this sense to independence over, for instance, a federal arrangement or devo max (something most people would actually support, unlike independence).


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    2. Independence itself will add significantly to the costs of import export. Unless the scots are proposing the rUK make their immigration policy for them, independence means border checks. The impact of that would be, in my view, much greater than the impact of having a different currency or not, assuming the exchange rate is quite stable.

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  3. Mr Draghi's intervention last year certainly convinced the market that peripheral debt had a a eurozone buyer of last resort. Do you think that the current spreads in bond prices reflect economic fundamentals?

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  4. As a starter for ten - and simply accepting the points made - the chance to have a less bloated military budget I.e. redirecting existing spendinginto more productive areas, would be nice. As would spending help to buy funds on building social housing. Etc., etc.

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  5. The process will in the end evolve the way it did in Czechoslovakia: promise to keep a common currency, drop the idiocy after three weeks, after a year nobody died of it and after ten everybody understand it was the right thing to do.
    When the Québec independance referendums happened, I always told my students that, monetarily, what Canada and Québec need wasn't two countries with the same currency but one country with five or six currencies.
    As for expropriating Scottish oil revenues, isn't the way England financed itself in the last 30 years, going as far as unilaterally changing Scottish territorial waters?
    In the end, of course, rationality could have been effective in the Czech-Slovak case as both , while not that warm-hearted toward each other, never felt the same utter contempt in for each other that rUK and ROC (rest of Canda) political elites hold for Scotland or Québec...

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  6. Scotland's best option; an independent currency, directly administered by Government and subject to tight controls. Their next best option; a currency union with UK. Last; independent currency administered by a central bank and open to international markets.
    But why should they have an initial deficit? If you take my first option, at independence they would have a major asset - their newly minted currency. Properly invested, the proceeds from the currency swap could balance any fiscal deficit for several years? But I doubt the SNP would consider a currency not owned by a central bank, since that is very unfashionable.
    But Independence should be a boon for Scotland even if they have to settle for the worst currency option.

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    1. They would have an initial deficit because all western countries have deficits. The UK is running a deficit now and will for the forseeable future. Scotland is running a deficit now, according to the Scottish government's own figures. The SNP are proposing to increase spending and cut taxes. There's no way they will be in surplus.

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  7. Nick: In the first case, why the need for tight controls? Because somehow international finaciers would panic at the thought of natives having seized the castle? I remember how during the 1995 Québec referendum , an English-Canadian finacial adviser was telling his customers to leave Québec. He was peddling them mutual funds in the Baltic states right next to a decomposing Russia and some Hon-Kong funds two years before the Chines take-over...
    "Last; independent currency administered by a central bank and open to international markets." Why last?
    This is the Norway-Sweden model. The only functionning one in Europe...

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  8. Surely the "credit risks" on Scottish debt are largely dependent on the oil revenues it can secure. This is the big unknown. I don't think the SNP are interested in a monetary union, it is just there to narrow down the degrees of freedom in an independence scenario; the SNP and the UK government know that in referendum's people tend to vote conservatively.

    Either way, a currency union without fiscal union could work. Look at the (teflon) euro. It's not the disaster that it is portrayed to be.

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  10. For what it's worth, bookmakers have put the odds of a currency union in the event of a yes vote at 1/100.

    http://www.liveoddsandscores.com/press-releases/512129/scotland-1100-to-enter-currency-union-501-not-to

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  11. If Scotland administered its own currency the interest rate on Scottish pound bonds would not be set by the market. The Scottish central bank and/or government would set the risk-free rate itself just as the Fed and the BOE do. If they want higher interest rates they can issue bonds or pay interest on reserves. If they want lower rates they can print money.

    The government could set the interest rate and budget deficit size at almost any level they want, based on what they think is best for the Scottish economy.

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  12. Claim to retain the pound and print their own money anyway.

    Duplicity is the stock in trade of politicians -- why not.

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