Everybody knows that the financial crisis has put a dent in the ambitions of Scottish nationalists. Alex Salmond’s “arc of prosperity” comparisons to Iceland and Ireland turned from inspiring to embarrassing almost overnight. It also didn’t escape anyone’s notice that the two largest banking basket cases were headquartered in Edinburgh, with titles that included “of Scotland”.
Scottish nationalists may struggle to overcome the political consequences of all this. But the crisis also created a profound economic obstacle to independence: the UK government’s large and rising debt. Westminster’s economic policies may prove too much for Holyrood to handle.
The essential problem is that an independent Scotland would struggle to deal with a debt burden that the UK as a whole finds manageable. This isn’t fair – but that’s the bond markets for you.
Exactly how much UK debt Scotland would shoulder would be negotiable, but there are estimates. One, by Angus Armstrong and Monique Ebell for the National Institute of Economic and Social Research, puts Scotland’s likely debt burden at 86 per cent of GDP in 2016/17, using Maastricht treaty definitions. This assumes Scotland acquires most of the UK’s oil and gas but only 8.4 per cent of the UK government’s debt, in line with its population. (Armstrong and Ebell outline other possibilities, many less favourable to Scotland.)
Is that 86 per cent a big number? In some ways no: it’s less than the debt/GDP ratio the continuing UK would face, and the UK has so far faced no trouble finding lenders to finance its continuing deficits.
But a realist would have to look at that debt/GDP ratio as a serious problem for Scotland, and not just because it is a world away from the 60 per cent limit customarily demanded of eurozone entrants. Scotland would be an unknown quantity to international bond investors. It would be a small economy, dependent on volatile hydrocarbon revenues, with no liquid market for sovereign bonds yet established, and no track record.
The likely consequences: higher interest payments. And with a debt/GDP ratio approaching 90 per cent and (just like the rest of the UK) a substantial ongoing deficit, high interest payments would be painful. All of this would have been a non-issue before the crisis broke.
Then there’s the transition: Scotland could not simply assume UK government debt, because bondholders have lent money to the UK government, not to Scotland. Scotland would presumably need to borrow, oh, £125bn or so – either from the rest of the UK or from the bond markets – and use it to retire its chunk of UK debt. That’s a lot of money to raise all at once, and even a small premium on that transaction would cost each Scot hundreds of pounds at a stroke.
The debt problem bears directly on a more familiar debate: what currency should an independent Scotland assume – the euro, sterling, or a Scottish currency? The euro is out of the question for now. Before the crisis, the UK’s (and Scotland’s) debt/GDP ratio was well inside eurozone accession criteria. It has roughly doubled since.
Sterling would be a tricky choice too: Scotland would have to run a contractionary fiscal policy to stabilise its debt in the face of a possibly sceptical bond market. That would be tough to do if Scotland had ceded control of monetary policy to a non-Scottish central bank (just ask the Spanish).
The most likely option is an independent Scottish currency. That would give Scotland’s government room for manoeuvre by printing money, though it would also increase the likely interest rates on Scottish debt, as investors would want compensation for the risk of a currency devaluation.
Scotland’s future debt burden is not a fatal obstacle to independence. And it is not Salmond’s fault. But it has become his problem.
‘The Undercover Economist Strikes Back’, by Tim Harford, is published by Little, Brown