VoxEU Column Europe's nations and regions Monetary Policy

Scottish independence in an interdependent world: New evidence

The UK and Scottish governments are engaged in a set of parallel and overlapping games in the economic and political arenas. This column presents research that analyses how decisions about whether to cooperate over financial regulation, fiscal rules, and the choice of currency and monetary policy, will all have far reaching implications for a newly independent Scotland and the rest of the UK.

Any economy must have a policy framework designed to manage the three basic macroeconomic imbalances:

  • The private financing (savings-investment) gap;
  • The public spending-revenues (fiscal) gap; and
  • The foreign financing (trade) gap.

These imbalances imply a need for financial regulation, fiscal rules, and a currency/monetary policy choice, respectively. A newly independent Scotland would be no exception.

Previous studies have analysed particular sections of the Scottish economy in isolation, without recognising their interplay with other sectors, or tracing their impact on rest of the UK. This study is the first, and perhaps only one, to examine a framework which recognises the links between these gaps and their interactions, while at the same time analysing the impact on the rest of the UK.

The analysis exposes the fact that the UK and Scottish governments are engaged in a set of parallel and overlapping games. A parallel game is one where the same opponents play against each other in more than one arena at the same time; in this case – the political and economic ones. In an overlapping game each player faces different opponents, and the strategies pursued in one game limit the strategies available in another. This is an economic game where the UK and Scottish governments play not only against each other, but also against the private sector. It impinges on the political game.

The solution to these games shows how the threat points – the best outcomes that each player can expect to achieve without cooperating, accommodating, or otherwise making concessions to the other – will alter from their ex ante status quo.

Monetary policy implications

The currency choice question poses a dilemma for both governments. Since the UK government cannot prevent Scotland from taking the pound if it wishes, nothing changes for Scottish monetary policy if London refuses to share the sterling and its monetary policy, since it doesn’t share them now.

Given independence, the only difference would be that Scotland would add tax powers to the existing monetary set-up. So, it would be unambiguously better off – more policy instruments to serve the same targets – instruments that can be designed to fit Scotland's specific needs rather than the UK average.

The cost would be no Scottish input into monetary policy (which is to leave things as they are), and the absence of liquidity support and a resolution mechanism in the financial sector. Since Scotland would at best have one vote in ten in forming monetary policy in a full union, and could make use of the EU’s banking union (as Denmark does, also not a euro member), blocking the full currency union would have little practical effect.

Financial regulation

Scotland can ‘opt-in’ to the EU banking union, in the absence of full monetary union with the UK, giving her financial sector better access to the Euro-markets and a wider pool of resolution funds. The threat point of the economic game therefore shifts again with consequences for the political game, because blocking monetary cooperation makes a wider political union look risky and less attractive.

In fact the rest of the UK would be no better off since monetary policy would be set in exactly the same way as now, and worse off to the extent Scotland uses her new tax powers to her own advantage rather than the rest of the UK’s; also because the rest of the UK would lose some tax revenues.

Fiscal policy

The link to fiscal deficits/debt is now obvious. The loss of fiscal transfers from London will be more than compensated by the return of tax powers, meaning a diversified set of revenues and fully functioning automatic stabilisers, supplemented by an oil fund to stabilise energy revenues. Also, research shows the bulk of risk sharing in mature currency unions is borne by cross-border asset holdings and loans. That aspect is preserved if the existing currency is maintained.

The fiscal deficit itself, if existing forecasts based on current practice are correct, would have oil revenues (still positive, if falling) added to it, plus repatriated taxes from commuters, eliminating pension payment subsidies, and lower debt interest payments to the rest of the UK – implying a small surplus over current payments.

That, in turn, provides the link to credit markets. If the existing models predicting risk premia for Scotland are correct, then the absence of material fiscal deficits and debt would lead to interest rates lower than in the rest of the UK after an initial period. Combined with a separation of private from public risk (the banking union resolving the former, a fiscal council the latter), this will lead to lower market rates. Similarly, the combined effects of Vickers, conduct regulation, EU regulation, and Basel III, will reduce the financial assets under Scotland’s supervision to the level of GDP.

Thus, as the Standard and Poor’s ratings assessment recognises, independence imposes ‘significant but not unsurpassable’ changes and risks on both sides.

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