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.