Devolved borrowing would create the same mess as giving Indy Scotland a currency union

This hurried post, that I would have liked to think about much more carefully, is prompted by the all-party promise for more devolved powers for Scotland, in the event of a ‘No’ vote, and also the provocative paper put out by the National Institute for Economic and Social Research by Angus Armstrong and Monique Ebell.

I don’t think that we should be offering Scotland devolved powers to borrow independently, incurring deficits and running up debt.  Doing so risks creating the same eurozone style mess that would result if the Rest of UK offered a newly independent Scotland a currency union without fiscal union.

First, such a system would create what is known as the ‘tragedy of the commons’.  The name refers to the situation where individual farmers have an incentive to overgraze common grass land with their cattle, collectively ruining the land.  It’s not in the interests of any one farmer to behave better, because doing so won’t encourage the others, and they will simply get less grass themselves.  Fiscally, overgrazing means overborrowing, taking advantage of the protection of the Federal authorities and the central bank that they sponsor.   This might not be a big deal, because of the much greater size of England relative to others (as Armstrong and Ebell point out), but it would still be unfair on the English.  And, who knows, perhaps it would be an existential problem.  The eurozone was hobbled by three tiny states (Greece, Ireland and Portugal), and the contagion it fed to larger ones.  Whatever problems are caused in this way could be eliminated by establishing credible central institutions that promise not to bail out one of the individual countries in the event that they get into difficulty.  But trying to set up such institutions from scratch is not easy.

Second, the crisis has taught us that the old way of doing macroeconomic stabilisation – having fiscal policy on autopilot, letting monetary policy do the work – isn’t adequate.  As Simon Wren Lewis and others have argued, nimble, discretionary fiscal policy IS needed, and urgently so, in the event that the economy encounters the zero lower bound to interest rates, where conventional monetary policy tools can do no more.  Devolving the power to borrow will weaken the fiscal room and coordination power retained by the centre to enact a powerful fiscal stimulus.  We won’t be able to rely on the individual fiscal units to borrow and spend separately, because it may not be in all their interests.  Witness the sorry tale unfolding in the eurozone, with those governments that don’t need a fiscal stimulus for their own economies (eg Germany) naturally reluctant to implement one for the benefit of the euro area as a whole.  Unconventional ‘monetary policy’ tools used by central banks don’t offer a way out of this problem because they involve the central bank taking large fiscal risks that have to be underwritten by the central government.  (This is why German ECB board member Weidman is against the ECB’s planned purchases of private securities).  Such underwriting requires that adequate fiscal ‘room’ to bail out the central bank if needs be is maintained.  And for me that rules out devolved borrowing.

Third, devolving the power to borrow inhibits risk-sharing, as Adam Posen argued powerfully in his article imploring the Scots to vote ‘No’.  ‘Risk-sharing’ sounds like a technical detail, a piece of financial arcana.  But it’s not.  It goes to the heart of what the public sector is for:  rule for dishing out resources to the unfortunate, funded by the fortunate.  Huge, slow to materialise risks like longevity uncertainty combined with defined benefit pensions;  quick to materialise risks like natural disasters or financial crises, or conflicts:  devolved borrowing weakens mechanisms to channel funds from the lucky to the unlucky people in the UK, and at a time when there seems to be a lot of risk about.

UK political parties have (rightly) ruled out offering a currency union to an independent Scotland, calculating (I think correctly) that the Scots would not accept, or be able to follow through on the fiscal promises required to make that viable.  For the same reasons, I hope that the devolution promises made today don’t entail much in the way of powers to borrow (we can’t tell yet).  Because if they do, they would risk creating the same mess that the curency union they won’t offer would entail.  Whatever the heartbreak, separation would be better than setting up an ineffectual fiscal federation.