Economics 101: The Scottish Edition

Scotland is set to vote next week on independence from the United Kingdom and a Scotland’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.

Get The News You Want

Read market moving news with a personalized feed of stocks you care about.

Get The App

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. The message, once again, is that wisdom in the dismal science remains cyclical rather than cumulative.