Economics Isn’t Physics: Scottish Edition

Scotland is set to vote next week on independence from the United Kingdom and a new poll gives the pro-independence supporters a small edge for the first time. What’s interesting, and perhaps tragic, about the growing preference for breaking free of Britain is the apparent dismissal of the economic consequences that may arise from independence. The macro risks are quite stark. In fact, we’ve had a real-world test that’s ongoing of just how bad things can get when a small economy is on its own with fiscal matters but remains tethered to a currency that’s controlled by another government. This could work out, but just ask officials in Spain or Greece–or the (unemployed) man on the street, for that matter–about the downside to a shared currency while shouldering any fiscal fallout and you’ll get an earful.

Yet its politics and national pride that seem to be in command. Economic lessons, which continue to unfold for all the wrong reasons via the Eurozone, seem to have dwindling influence. “I think we will make a better job of running the country ourselves rather than having decisions made by the UK government,” saysScotland’s finance minister John Swinney. Although the risks of sharing a currency while shouldering fiscal independence are well known, particularly in the wake of the euro debacle, Swinney insists on going down this route, apparently blind or indifferent to history. Last month he insisted that Scotland remain in a currency union with Britain after independence. Otherwise, Scotland won’t pay its share of UK debt, which is valued at £100 billion–roughly 40% ofScotland’s economy.

This all sounds rather cavalier and dangerous given the empirical record on suboptimal currency unions. As Paul Krugman writes today in his New York Times column:

Everything that has happened in Europe since 2009 or so has demonstrated that sharing a currency without sharing a government is very dangerous. In economics jargon, fiscal and banking integration are essential elements of an optimum currency area. And an independent Scotland using Britain’s pound would be in even worse shape than euro countries, which at least have some say in how the European Central Bank is run.

I find it mind-boggling that Scotland would consider going down this path after all that has happened in the last few years. If Scottish voters really believe that it’s safe to become a country without a currency, they have been badly misled.

Sam Bowman, research director at the Adam Smith Institute, makes a similar point via The Financial Times:

In many ways a currency union would be business as usual for Scotland and the least problematic short-term option. However, EU regulations may still require RBS and Lloyds to domicile in the City even under a currency union. In addition, Scottish sovereign debt may trade at artificially low rates thanks to the implicit backing of the BoE, encouraging unsustainable borrowing.

Most seriously, without fiscal transfers between Scotland and the rest of the UK, there is a danger that Scotland would not be able to do anything in response to demand-side shocks to the economy, potentially resulting in prolonged and harmful periods of deflation for Scotland.

The bottom line, as Lisa Tripp at Atlanta’s John Marshall Law School recently observed in her paper “Lessons for Scotland from Greece’s Euro Tragedy”:

In a pound-based currency union, for example, the Bank of England would make all of the key monetary decisions (setting interest rates to achieve target inflation and unemployment rates, determining how much money to keep in circulation, etc.) in the best interests of the union as a whole. These decisions directly impact economic growth, employment, the ability to pay debts, the strength of the currency relative to other countries’ currencies, which affects export competitiveness, among other things. Since England’s economy dominates the UK, the Bank of England would make monetary decisions that favor England, because what is best for England is best for the union, even if those same decisions were at the expense of Scotland’s economy.

An alternative for Scotland is to launch its own currency, but that comes with a hornet’s nest of potential troubles for a small and untested economy. In the worst case scenario, borrowing costs for the newly independent nation could and probably would rise sharply relative to what it pays as a card-carrying member of the pound sterling club.

There’s always the possibility of joining the euro, but it’s hard to imagine that this option would have any support given recent macro events. Then again, if the lessons of economic history resonated in the first place then Scotland would refrain from independence. But politics seems to be the driving factor behind the growing allure for this macro gamble, proving once again that no one should confuse analysis and choices in big-picture economic matters with physics.Wisdom in the dismal science remains cyclical rather than cumulative.

This piece is cross-posted from The Capital Spectator with permission.

2 Responses to "Economics Isn’t Physics: Scottish Edition"

  1. Macro75   September 10, 2014 at 7:24 am

    The cautionary advice is certainly pertinent, but two assumptions in the arguments positing Scottish independence as a macro train wreck waiting to happen are that first, business cycles in Scotland and the UK are or will be out of step, and second, that monetary policy from the BOE will almost always be suboptimal for Scotland. On the first point, business cycle synchronicity in Scotland and the UK should remain strong even of the Scots go out on their own. On the second point – which is related to the first – BOE policy should thus serve Scotland well. Does anyone really believe that macro conditions in Scotland played a significant role in monetary policy decisions made in London? I highly doubt it. So arguments that propose that Scotland would be worse off – necessarily – by pursuing political independence, seem a bit overblown. Not all small countries using another currency are destined to be Greece. Hypothetically Scotland will face significant risks. Hypothetically, Scotland should also do OK.

  2. trodavid   September 11, 2014 at 8:12 pm

    The logic of the author's argument escapes me. Mr Picerno makes a pretty big deal out of the fact that BoE will be making its decisions on the basis of England's needs and not Scotland's. I find this disingenuous, or something. As Macro75 points out, there is absolutely no reason to assume that BoE is not already doing this.
    Indeed, one of the reasons, or perhaps the major reason for the Scots to leave the English political union is precisely because they feel that decisions made in London reflect the needs of England more than of Scotland.
    Is there some hidden agenda to Mr Picerno's argument, or is this just the same old same old defense of the status quo because it is the status quo? I don't know.
    However, there is one other point which Mr Picerno totally ignores. There is no natural law or philosophical rule that says that a country can and should only make its decisions based on economic considerations.
    There are, in fact, other things in life than the pursuit of the most luxurious possible living standard.