Currency and Fiscal Policy Options for an independent Scotland

Lead Research Organisation: National Institute of Economic & Soc Res
Department Name: National Institute of Economic & Soc Res


The objective of this Fellowship is to stimulate an open and informed debate on the coherence of alternative currency and fiscal arrangements for Scotland. This issue is at the heart of whether full or further devolution will be successful. Since independence is likely to be irreversible, at least for several years, an informed debate requires understanding all of the currency and fiscal options across a spectrum of sovereignty rights, whether or not they are part of a referendum.
Scotland's future currency and fiscal arrangement is at the heart of whether full or further devolution will be successful. The Parliament of Great Britain with full currency, fiscal and political union began with the Acts of Union in 1707 and has endured longer that all other monetary unions between nations. Monetary unions which have logical inconsistencies have always been eventually exposed by an unforeseeable economic shock. History is replete with instances in which failed unions lead not only to economic crises but often political division. The academic community has a responsibility to propose currency and fiscal arrangements which have integrity and be unapologetic in highlighting those which are inconsistent.
The current economic crisis shows how failure to understand risks and misaligned incentives in the financial system can undermine policy frameworks. The number of financial crises around the world over the last three decades, and in particular the recent global crisis, shows how private sector risks can become public sector liabilities as the state remains the ultimate insurer of systemic risk. With the large transfer of financial sector exposures to the public sector the previous working assumption of a division between currency (or monetary) policy and fiscal policy has become exposed as an over-simplification.
The traditional approach of an optimal currency area developed in the 1960s must be extended to include financial sector risks. Only when financial sector risks are fully incorporated can the integrity of the new currency and fiscal arrangements be judged. This Fellowship aims to make this extension. The liabilities of the banking system are assumed to be contingent fiscal risks of the state. This brings financial supervision and non-monetary policies (i.e. bank support policies) by the central bank into the centre of the debate. This creates a clear link between monetary and fiscal policies. These risks are central to Scotland - a small and open economy with a large financial sector. Failure to consider currency, fiscal and financial arrangements together would be a serious omission in this debate.
This Fellowship will examine Scotland's currency and fiscal policy options from a joint macro-economic and macro-financial perspective. The macro-economic perspective looks at the structure of an independent Scottish economy (more oil-based and without the Barnett fiscal transfer) and fiscal sustainability. The core of the Fellowship is building the first large-scale global econometric model of Scotland. This will be an extension of NIESR's National Institute Global Economic Model (NiGEM) which has over 40 model subscribers, mainly in the policy community, including the Bank of England, the FSA, the ECB, the OECD, the IMF. The macro-financial perspective will focus on the Scottish banking system as a state contingent liability. The key issues are what are the choices of institutional arrangements for providing financial sector support (such as lender of last resort and deposit insurance) and who will be the regulator. While it is possible to contract-out these operations, this will involve a fiscal cost and raise moral hazard issues.

Planned Impact

Who and How
In the public sector the Office of Budget Responsibility and Scottish Government will benefit by having a fully integrated global econometric model with Scotland included. Both institutions have approached the NIESR with regard to developing this model. This will help them in their economic and fiscal forecasts which are the foundation of setting the annual government budgets.
The Bank of England will also benefit from the same global econometric model of Scotland. Whatever the outcome of the referendum it will be beneficial to have a detailed model of a significant part of the UK economy. The Bank is already a user of our model. The Bank is also expected to benefit from having an independent valuation of the cost of central bank support measures. These costs ought to be paid by the beneficiary - the banking sector.
Businesses in Scotland, particularly the financial sector, will benefit from an open and non-partisan discussion on the future of financial regulation and the institutional framework for supporting the financial system.
If the Institute for Fiscal Studies have a "Green Book" for Scotland then the overall macroeconomic setting of any future budget will need a macro-economic model. We would be pleased to support the IFS using the NiGEM with Scotland model.
The IMF and OECD consult with NIESR when carrying out their annual Article 4 economic assessments. It is highly likely that both institutions will take a close interest in the independence debate and the potential economic consequences as the referendum draws closer. As we have close relationships with both organisations, we would certainly be asked to share our work and the version of NiGEM with Scotland (they are both subscribers).
The currency and fiscal choices facing Scotland are certain to be at the centre of the public debate in the lead up to the referendum. We hope that the arguments and evidence we are able to provide through this Fellowship will lead to a far higher understanding of the issues on both sides of the debate.
The public is NIESR's most important stakeholder. We hope that through our Pathways to Impact we have shown how we intend to engage with the public, across all sections, and that they can therefore benefit from our findings helping them to make an informed decision in this momentous referendum.


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Description In our research we explained the currency options, likely division of assets and liabilities, possible borrowing costs and financial sector consequences of Scottish independence. These issues were at the centre of the independence debate.

Are findings indicated that an independent Scotland would be unlikely to form a fromal currency union with the rest of the UK due to the amount of debt it would assume if it became an independent nation. In the event of an independent Scotland entering into an adverse economic situation, its high debt level (assuming it accepted a per capita or GDP share of existing UK debt) would limit room for fiscal mobility and its lack of effective representation at a central bank would rule out monetary policy. The consequences could be that borrowing costs rise further possibly destabilising the economy.

We carried out a detailed econometric study to estimate the borrowing csots for an independent Scotland. We estimated that these would be between 0.68% and 1.62% higher than for the rest of the UK and its banking sector would be largely based on bank subsidiaries from the rest of the UK.

We showed how a banking union between tow such different sized nations would be difficult to achieve. This is because the large country could always bail out the samll country but the small country could not bail out the large country. Scotland is 8.5% of the UK. Therefore, this begs the question of why the rest of the UK would enter this agreement.
Exploitation Route 1. Monetary and banking unions with asymmetric sized countries
2. Issues in providing cross-border lender of last resort arrangements in Europe
3. Approaches to sub-central government borrowing costs in the UK
4. The limits to risk sharing in banking unions (EU)
Sectors Education,Financial Services, and Management Consultancy,Government, Democracy and Justice

Description Our research findings were frequently cited in reports by the UK and Scottish Governments, in debates in both parliaments. The issue of currency was central to the debate and we were recognised as the main independent authority on this issue. Our work was cited many times by Danny Alexander, Alistair Darling and senior Scottish Government officials commenting on the importance of our work. We were frequently on leading TV and radio discussing the issues such as the Today Programme, BBC News 24, Sky News nd Newsnight. Our work was regularly cited by the UK and international media. According to our media count service, our research was cited in the media over 1000 times in the year before the referendum (an average of around 3 times per day). We provided evidence as expert witnesses to select committees in both the Scottish and Westminster Parliaments on many occasions including the Treasury Select Committee, Scottish Affairs Committee, the Finance Committee, Economic Energy and Tourism committees and as Special Adviser to the House of Lords Economic Affairs Committee. We took part in many public debates including at the British Academy, Royal Edinburgh Society, Royal Economic Society, Scottish Econoic Society, Glasgow, Stirling and Edinburgh Universities as well as for many privately supported events. Our research was published in chapters in three books, three refereed journal articles, discussion papers and speeches and blogs. We also experimented with innovative media such as an annimation for YouTube which has been watched by 186,000 viewers. Our findings were cited in almost every major investment banks' research and by all of the credit rating agencies. In the EU referendum some of the issues raised were again referred to. This is particularly the case for financial services. In 2021 with the possibility of a second Scottish Referendum looming, we have been asked to engage one again in these issues. An important research report published by the ESRC Centre CEP references our papers from this project as key research in this area. We aim to add a discussion paper adding a further dimension through our ESRC Rebuilding Macroeconomics grant.
First Year Of Impact 2013
Sector Education,Financial Services, and Management Consultancy,Government, Democracy and Justice
Impact Types Societal,Economic