Shared debt and common currency

Scottish notes The NIESR report looks at debt and includes a "thought experiment" on currency

Whether it's 'Yes' or 'No', we're burdened with a whole lot of government debt.

That's at least one conclusion of a report from the National Institute for Economic and Social Research.

One big question is how much better or worse it looks under independence.

The report has calculated that an independent Holyrood administration could inherit a debt of £143bn. That's being seen as the conventional 'Maastricht' measure for government debt, and comes in at 86% of Gross Domestic Product. If that seems a lot, consider this: on that reckoning, the UK would have total debt of more than £1,700bn.

To fund that population-based share, it's reckoned that an independent Scotland would have to borrow at least £23bn in its intended first year, 2016-17.

That's the cost of meeting interest on debt, as well as re-financing of maturing UK debt. And on top of that, there would be a few billions in funding year one of deficit, to be raised directly from the bond markets, as Scotland is on track to continue the pattern of UK spending a lot more than it taxes.

All that, then, is close to the payments Scots would be paying through the Treasury if it were still part of the UK.

'Clean break'

There are technical questions of how that debt is paid off, but they're important ones. If Scotland inherits a population-based share of debt, the £23bn payment would be by paying interest on a share of UK debt until it matures, and then refinancing it on Scottish terms.

One catch is that this, technically, pushes up the debt for the rest of the UK to more than 100% of its Gross Domestic, and the bond markets could exact a price for that.

Alternatively, a 'clean break' could see a payment from Scotland of £102bn - less than the inherited figure because the Treasury in London would no longer have to pay the interest on that borrowing. That's money Scotland would have to raise very quickly, so it's not the preferred option of the Scottish government.

A key element in this is the cost of borrowing. The Institute's Angus Armstrong has already reckoned on the borrowing rates Scotland might face, concluding they would be higher. That's not primarily because of higher risk, though there would be an element of that in a country that has no credit history, but because there's a less liquid market for smaller country debt.

As NIESR points out, Finland and the Netherlands have better fiscal positions than Germany, but pay a premium for being smaller and selling their bonds into less liquid markets.

That's the main reason why the NIESR reckons an independent Scotland would pay between 0.72% and 1.65% more than the UK rate for 10-year bonds. These gilts were today trading at 2.69%, having lost a lot of the advantage of cheap borrowing the UK has had through the eurozone crisis - even Ireland is borrowing at less than 3%, and France, Belgium and Austria are at much lower rates than the UK.

Thought experiments

The NIESR goes on to run "two thought experiments". In the current state of the debate on Scottish independence, that sounds a risky thing to do.

They require several assumptions about oil tax revenue, inherited debt and growth rates - all of them hotly contested - to conclude that an independent Scotland would face a significantly tougher squeeze on its public finances than the UK as a whole.

That's if it's to get to the 60% target for government debt which is seen as the ceiling for euro membership - not because anyone's arguing for euro membership, but because that's a target for good fiscal management.

Sterling effort

All of this may be academic if the government of an independent Scotland says it won't take on a share of debt. That's the threat ministers have issued unless Holyrood also gets to retain some shared control over the sterling currency.

The NIESR is wading into more controversial territory with its take on that question. But it's worth setting out.

What it says is that an independent Scottish government cannot share its currency. Not that it should not, but that it simply cannot.

It says that the Bank of England has an asset value in the UK government accounts, but it's not the value that the Scottish government has in mind. The accounts say its net worth is £340m, which is probably around the value of its headquarters on London's Threadneedle Street. Scotland could expect perhaps £29m as its share.

So what about a share of its currency, which is what the Scottish government is after? On this, the NIESR takes the side of the UK Treasury, saying the pound is a valuable currency, but its value comes from the support, commitment and reputation built up by successive governments over more than three centuries.

"Reputations are incomplete contracts because they can be partly shared, but they cannot be transferred," says this report. "It is simply not possible for the continuing UK government to transfer part of this reputational value to another government, even if it were inclined to do so".

Yes, it's conceded, the rest of the UK could choose to share reputational value and its taxpayers commitment by extending the powers of the Bank of England to operate in the interests of an independent Scotland. But the three main Westminster parties say that would not be in the interests of their citizens.

So the argument seems to be that protection of a currency's reputation can be extended beyond a nation's boundaries. But it can't be transferred. And to retain that reputation, control would remain where it is.

A change to accommodate an independent Scotland and share controls would effectively require a new currency to be created, and it would have to establish its own reputation.

Flag-carrying

Muddled? Well, probably not as muddled as the UK government's position became when one senior minister reportedly thought out loud that a deal could be done on sharing the pound as it is.

If the NIESR is right, that might be neither desirable for the rest of the UK, nor possible.

And it all becomes a lot simpler if you read John Kay in the Financial Times on Wednesday. Formerly on the Council of Economic Advisers to the Scottish government, he's arguing that an informal use of sterling could be workable, if not quite attractive. Obstacles or drawbacks could be removed, particularly if there's to be a European banking union.

Wouldn't Scotland lack influence over sterling interest rates and monetary policy? Well, yes, says Professor Kay, but it wasn't likely to have much anyway.

And, he adds, perhaps currencies will come to be seen as a badge of statehood that will become as much of an anachronism as the national flag-carrying airline.

Douglas Fraser, Business and economy editor, Scotland Article written by Douglas Fraser Douglas Fraser Business and economy editor, Scotland

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