The Scottish media has expressed some concern that Alex Salmond is "flip-flopping" over the issue of whether Scotland would have to sign up to a fiscal stability pact if an independent Scotland adopted sterling: here and here. In March he said we would, then in Chicago last week he said we wouldn't.
Let me set aside what this says about the clarity of the SNP Government's thinking on the economics of Scottish independence and the choice of currency in particular.
What is at issue here is not macho politics but what is in the best interests of the Scottish - and rest of the UK - people. There is no doubt in my mind that if an independent Scotland adopts sterling then it should enter into a formal monetary union arrangement with the rest of UK government and agree/accept a fiscal stability pact.
Let me explain why.
If an independent Scotland adopts another currency rather than creating its own this is technically known as dollarization. Dollarization offers several benefits to a small, newly independent country. It eliminates the risk of exchange rate fluctuations and reduces the risk of inflation.
The risk of exchange rate fluctuation is high for a small country vulnerable to large speculative international capital flows. The more so in a Scotland with an economy subject to the vagaries of variations in oil prices and revenues.
The risk of inflation comes from having one's own central bank and a discretionary monetary policy, including currency devaluation. Scotland would have no need for a central bank and monetary policy if it adopted sterling - effectively a foreign currency. The theory is supported by empirical evidence that inflation is significantly lower in dollarized states compared to non-dollarized ones.
It also makes good sense for an independent Scotland to adopt sterling because the process of developing the union since 1707 has led to the Scottish economy becoming significantly integrated with the rest of the UK economy. The majority of our trade is with the rest of the UK, the labour and capital market is highly integrated with the rest of the UK and there are large fiscal flows between the two. But the latter would clearly cease if Scotland left the union.
So, if that is the case for keeping sterling, why a fiscal stability pact?
The reason is that a fiscal stability pact would deliver lower borrowing costs to the newly independent Scottish government using sterling than without the pact. And those costs in turn are likely to be lower than if Scotland was completely independent with its own currency, at least in the first decade or more of independence.
This partly, but not wholly, turns on the question of the credibility of the government of an independent Scotland and its monetary and fiscal authorities. To put it crudely, a government and country with no track record in fiscal and monetary management is bound to have to pay a risk premium than a more mature state with an established reputation.
So, a 1995 OECD study found that
The most common explanation for these (cross-country) differentials (in borrowing costs) is the existence of financial risk premia which vary across countries. These risk premia can be broadly defined as the additional returns required by savers to compensate for uncertainty with respect to such factors as default risk, market volatility and inflation variability. Several interrelated factors are likely to influence the size of these premia, including the expected sustainability of government fiscal positions and perceived degrees of commitment to monetary discipline. ..... analysis suggests that the rate of return on capital, a country's past history of inflation, current-account balances and government deficits are all important determinants of trend real long-term interest rates - both as a group and relative to one another.
Dollarization removes the monetary discipline/inflation risk, while a fiscal stability pact reassures markets about the sustainability of the government's fiscal position.
It is simply wrong, and also beside the point, for the Scottish government to argue that
Scotland is in a stronger financial position than the UK as a whole, and therefore will have no difficulty adhering to fiscal discipline within a sterling zone as an independent country.
It is wrong because, as I have shown here, the evidence is that Scotland has a fiscal deficit which can be described as 'structural'. This is because even with a geographical share of oil revenues the deficit has averaged above 3 per cent of GDP, when the initial oil production years are excluded. A situation which is worse than the UK. Moreover, oil revenues are strongly predicted to be in decline and are highly volatile, accounting currently for 12 per cent of Scottish government revenue.
It is beside the point, because the fact that the UK may also have run fiscal deficits for some time, or currently has a high debt to GDP ratio, says nothing about the credibility of a Scottish government in fiscal management. In contrast, the credibility of UK government fiscal management is well established going back to Elizabethan times.
But even within a stability pact, it is almost certain that an independent Scotland will be subject to higher borrowing costs than the UK, for three reasons.
First, the stability pact is unlikely to remove completely the credibility problem facing a recently independent Scottish government, with no previous experience of, and reputation for, fiscal management. That problem is likely to be worsened by both the high levels of debt that will be inherited by the new Scottish state and the fears of a continuing structural deficit, which will have to be financed.
Secondly, Scotland is much smaller relative to the UK and its finances are likely to be more volatile because of its size. So, to return to the OECD study cited above:
Some possible explanations for an additional (small country) risk premium could include: domestic and foreign assets not being perfect substitutes, leading to home-country preferences on the part of large country investors; the relative depth of financial markets, with larger countries perhaps offering more variety in terms of the types of assets available; and greater concern over a smaller country's policy stability, given their greater exposure to exogenous external shocks.
Scotland's dependency on oil revenues is an additional factor increasing the risk of volatile tax revenues and hence the demand for a risk premium by purchasers of Scottish government bonds.
Finally, an independent Scottish government that chooses sterling, for the very good reasons noted above, will effectively be borrowing in a foreign currency. The implication of this is that the financial markets will perceive Scotland to be a greater default risk compared to a state that can meet its obligations by printing its own currency.
A fiscal stability pact plus some agreement with the UK government on the Bank of England acting as a lender of last resort, hence ensuring liquidity to both government and banks, will be a major factor in helping to keep borrowing costs low.
But even then, we should still expect the Scottish government to have to pay a risk premium in its borrowing compared to the UK for the reasons outlined above.
And no amount of political posturing is going to change that.