Currency and Fiscal Policy Options for an independent Scotland

SUMMARY
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.

IMPACT SUMMARY
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.