Back in April, the Treasury published a report explaining, in short, that an independent Scotland could not be a member of a currency union, managed by the Bank of England, without considerable fiscal oversight. The Scottish National Party (SNP) dismissed this report as ‘scaremongering’.
In this post, I want to reiterate why the Treasury was right, and if anything understated the problem, (probably scared itself of being accused of scare-mongering). The SNP’s failure to address this important issue of institutional design reveals either incompetence on their part, or, worse, indifference to the future macroeconomic stability of Scotland and a determination to make sure that the Scottish electorate don’t grasp the issue. 10 years ago, this debate would have been much less clear cut because we did not have the example of the euro area on our doorsteps. Now, however, we can see clearly what happens when countries combine to form a currency union, but have independent fiscal and financial stability policies.
The short answer to this question is: without intrusive fiscal oversight, the currency union of the Rest of the UK [or RUK] with Scotland would look like the currency union in the Euro Area. Not good! In fact, even worse, because the size of the balance sheet of the banking sector in Scotland relative to GDP is much higher than say, the typical basket case Mediterranean country. And worse too because the exposures to Scottish banks of the UK probably exceed those of the European core to the periphery. So, it seems pretty clear to me that the RUK would not want to sign up to a currency union on these terms, contrary to the SNP’s assertions.
To spell things out a little more: the RUK would want to ensure two things. First, Scotland supervised its banks to the same standard as the RUK supervised its system. Second, that Scottish fiscal policy was sufficiently conservative as to be able to cope with a failure of its banks. Otherwise, in the event of a crisis, there would be irresistable pressure (just as for the European core now) to offer a bail-out to Scotland, so that it in turn could protect Scottish banks, and thereby protect RUK banks from a run as a result of worries about exposure to the affected Scottish institutions. Without these two guarantees in place, there would be every incentive for the Scots to free-ride on UK financial guarantees. The Scots might be tempted to offer lax capital or oversight, in the hope of retaining or attracting further domiciled banks, and obtaining the tax revenues that come with it, while relying on the incentive of the RUK fiscal authority to bail it and its banks out in the event of a crisis. [This is one way of reading Salmond’s response to the proposed acquisition by RBS of ABN Amro. He welcomed it because it beefed up the profits that would be billed to Scotland, and the tax revenues that he could argue should be hypothecated for Scottish spending].
This problem would be less severe if Scotland were forced to manage its own currency and exchange rate against the RUK, because Scotland would have the option of plugging the gap in its finances by printing that currency, and the fall in the currency that would be associated with a financial-sovereign crisis would stimulate export-led growth (just what the European periphery are lacking now). The knowledge that such an option exists would put an (inflation risk) premium on Scottish government bonds, but it would also lessen the likelihood of a run on those bonds and the banks that held them.
This is why the RUK government would not be content to maintain a currency union with Scotland without tight fiscal and financial stability oversight, which, in effect, amounted to a fiscal union. And the reasons, to repeat, are almost identical to those governing the struggle over how to work through the European crisis. Scots voting for political independence in order to achieve fiscal independence should not count on remaining part of the Sterling currency union.
Even with a floating currency, there would still be some incentive for a RUK government to offer aid to a Scottish sovereign having difficulty financing a bail out, or guaranteeing Scottish deposits to prevent a run on Scottish banks, and an associated plunge in demand for RUK exports to Scotland. (The funding for Ireland during the euro area crisis that the UK offered was not for altruistic purposes). And knowing this, there may well be some incentive to free ride in advance (with lax regulation and higher tax revenues accruing). So from this perspective only, namely, to ensure a watertight financial stability union, while Scottish and RUK banks are so intertwined, RUK voters should hope that the Scots vote no.
The analogy with Europe isn’t perfect. One of the reasons why Germany has not yet pushed to cut Greece loose is because of the precedent that might be set for Portugal, Spain, even Italy, and the worry that default and exit by these countries might become a self-fulfilling prophecy. There would not be the same problem for a RUK contemplating kicking out Scotland from a currency union in the event of a financial crisis. There would be no further entity within the currency union that might have to break away. For that reason it would be less traumatic for the RUK to force a Scottish exit in a crisis.
Another reason why the analogy isn’t perfect is that a currency union with an independent Scotland would happen with the experience of a Euro Area crisis fresh in everyone’s minds. One would presume that the real possibility of a break-up of the Scotland/RUK union would make a break-up itself less traumatic. For one thing, RUK banks would think carefully about the price they wanted to pay for Scottish bonds, and would not treat them as substitutes for RUK ones, as it appears that markets in general did when pricing euro area core and periphery bonds in the run up to the crisis.
But indepedence in a sterling union WITH the substantial fiscal oversight this implies is perhaps the option most consistent with preferences as revealed by polling: so called “devo-max” would win if offered; SNP were keen to offer it; UK parties were dead against (because it would win). Offering this constrained version of independence seems to makes sense given this.
Thanks very much for commenting. You make an interesting point I had not thought of. Although I would worry that the SNP have not spoken with consistent voices on this. If they had, they would have agreed with the Westminster Treasury Report. I also wonder if devo-max is, or widely understood to imply the pretty austere fiscal conservatism that it would require to make a currency union viable. Eg, to make it work, the Scots, with a larger financial sector relative to GDP, would have to tolerate much less counter-cyclical fiscal policy than the RUK. From where I sit, it looks to me like the SNP are arguing that one advantage of breaking away is that if, hypothetically, you were already independent up there, you would have had MORE counter-cyclical policy than us, not less.
I pretty much agree with you. Couple of points though:
# Scotland has lower share of GVA in financial services than rUK, so a process of partial deconglometerisation could deal with the relative size of the financial sector to GDP (for example RBS could make NatWest a wholly owned subsiduary headquartered in and regulated by rUK; whilst the institution that is RBS served the Scottish market and was headquartered in and regulated by Scotland; but owned the equity of NatWest).
# A lower ability to engage in countercyclical policy does not mean that the average level of tax and spend over the business cycle is lower; Scotland could be a more Scandinavian high tax high spend public sector even if (G-T)/Y was tightly constrained by currency union oversight.
These are good points. 1) I don’t think it would be satisfactory for RUK financial authorities for NW to be wholly owned by RBS; this would create a conflict of interest in a crisis. But complete divestment would obviously sovle the problem in part. (Scotland would still be tempted to offer its remaining banks easy terms on regulation to boost profits and tax revenues, free-riding on the RUK, and RUK would be wise to insist on either no currency union or unified financial oversight and unified associated fiscal backing (akin to the European Stability Fund). 2) To the extent that the Scottish financial sector is larger, proportionately, mean levels of spending would have to be lower, as larger shares of tax revenue would have to be set aside for insurance purposes. Risk is costly, so it’s not the case that it is simply about being less counter-cyclical. (If I move to an area at greater risk of being burgled, I end up poorer for either self-insuring (letting my stuff get nicked once in a while) or paying the premium every year. Insuring for a bail-out of the banks is no different. Scotland could be higher tax and spend than RUK, but, other things equal, it would have to ‘spend’ more on insurance of financial servies, and less on other things.
One more point. GVA(financial services)/GVA(Scotland) is the right ratio to judge the potential tax contribution from banks, but not the potential tax liabilities stemming from a criss. Those are related to the size of the balance sheet of banks (the potential size of retail deposits, for example, that the government might be tempted to guarantee, and therefore have to stand ready to make good). And to measure the ability of the government to attend to the crisis we have to divide that by the tax-base (which is proportional to GVA(Scotland). Hence it’s common simply to talk about the ratio of the balance sheets of banks to GDP.
What are Scottish banks? Are there not just Sterling banks? Don’t global banks pick and choose which jurisdication to declare profits in?
At the moment there are just UK banks. But the border would become significant. Global banks can pick and choose, but doing so requires particular corporate structures. A key thing is whether the subsidiary unit in the foreign country has its balance sheet guaranteed by the umbrella unit or not. If not, the local supervisor will demand that that subsidiary unit structure its balance sheet in a particular way, in return for the LoLR protection.
Is the Scottish financial sector just banks – fractional reserve lending with access to LoLR – or is it also fund management services, 100% collatoralised investment management and fee-for-service? What proportion of tax revenue comes from each?
I guess that the split is about 80 banks, 20 non banks, but just a guess. Key thing is the size of the banking sector balance sheet relative to GDP. Former measures what tax payer would be on the hook for. Latter measures the tax base from which bail out funds would come from. Chances are that if banking moved south, a large portion of non-banks would move to, since the business, and the staffing is interdependent.
Are countries bound to maintain the currency they use at independence, or may a new currency (fiat vs gold standard; pegged vs floating; digital vs paper) be introduced at a later date?
Countries can do whatever they choose. Changing currency arrangements involves lots of costs, so a country will be constrained by that. Costs both physical (could be changing vending machines, cash handling systems, or credibility costs, or costs associated with redenominating contracts, or costs paid by economic participants insuring themselves against future redenomination).