Full Fiscal Autonomy Theory

The debate on Full Fiscal Autonomy (FFA) for Scotland has raised a number of issues and concerns, not least what a terrible position it would put Scotland in fiscally, leading to extraordinary austerity. I don’t need to go over this again as Kevin Hague has already gone through the figures. These have not really been disputed (at least not in any informed manner). The main argument being used to counter the fiscal horror show presented is that this is a temporary blip, and Scotland will recover its fiscal balance and then off we go. FFA would actually be delivered when prospects were looking sunnier in other words. That this is unlikely in the short to medium term seems obvious, given the oil revenue collapse, but that is the argument made. Once achieved, and starting from a decent position, the growth from Scotland having its hands on the “levers of power” would bring growth that would lift us permanently into a better position. Well, OK, if you think so, though I note that Nats are very reticent on telling us what these new policies would be. The one idea they had, of reducing corporation tax seems to have been dropped and not much else has arrived in its place. Raising growth through government action....well, if it was really easy to do, they'd all be doing it. That is not really my problem though.

What I think hasn't really been discussed is what a terrible idea it is, even if Scotland was in a much better position than it is now. To think about this, we need to go back to the currency union debate that was at the heart of the independence campaign. Lets start with what makes a currency union work. In optimal currency area theory, there are normally four criteria with which to judge a currency union:

• 1.       Labour mobility
• 2.       Capital mobility and price and wage flexibility
• 3.       Similar business cycles
• 4.       Risk sharing automatic fiscal transfer

You can argue over points 1 -3, but I think we can safely say that the UK broadly fits these criteria; given how integrated our economies are after 300 years of union. It is point 4 that strikes me as important here.

Paul Krugman has touched on an independent Scotland’s position recently in his blog, and he does so (as he often does) by referencing Optimal Currency Area theory. He says:

This theory mainly focuses on the problem of responding to asymmetric shocks — a slump in Spain while Germany booms, etc.. We know, or we think we know, that when this happens fiscal integration — Florida can count on Washington to pay for pensions and medical care, Spain has no comparable cushion — is crucial. 

Krugman is discussing currency issues within an independent country, and that point is worth talking about. What isn’t mentioned though (probably because the FFA debate has not made it that far) is that so many of the issues also relate to FFA.

What FFA does (as independence would have done) is that it removes one of the key levers that keeps our currency union stable. Given a shock to one part of the UK, (an oil slump / a London property crash) then the automatic transfer of resources just would not happen. We could end up in the unhappy position of a Spain or Ireland, having to internally devalue within a currency union to get our country back to competitiveness. Why this could be seen as a good thing is beyond me. When countries within the Euro are thinking of mechanisms that would overcome this lack of fiscal balancing across state boundaries, for Scotland and the UK to abandon these seems to be madness. This idea then is not just bad in practice, as Kevin has pointed out, it is bad in theory too.We live in very strange times.