Two points are clear from the Scottish referendum debate. First, there are certain capabilities which the UK provides that are invaluable to all constituent nations. In particular, a successful currency union and a seat at the top table of the world’s leading international forums, such as the European Union and NATO. There may be other centrally provided capabilities which are highly valued, such as security and diplomacy. Second, there is a clear wish for genuine power to be transferred away from central government to local decision making. This is not simply a matter of more discretion over how to spend resources allocated via budget transfers, but real responsibility for economic choices to meet local needs. This paper argues that devolution can only be meaningful if Scotland - and, crucially, Wales, Northern Ireland and regions in England - have the power to borrow. Contrary to received Whitehall and Westminster wisdom, such powers are feasible and desirable.

The referendum is a simple binary vote about whether Scotland should be an independent country. In the event of a 'No' vote, the three main political parties have committed to devolve further powers in a new Scotland Act by January 2015. All three parties are offering greater spending and tax revenue powers, but little, or nothing, on borrowing capacity.(1) Yet, without the power to borrow, these new arrangements risk throwing the last one hundred years of economic thought out of the window. Real devolution means that the Scottish state can succeed or fail – and if it fails, it must not count on the rest of the country to step in and rescue it. That must mean devolving borrowing power. Only then will local representatives be responsible for their actions and then held to account by the electorate. The difficulty for the UK is the deep-seated doubt about devolving borrowing powers away from the centre of government. Indeed, Parliamentary sovereignty is founded on a civil war fought precisely to gain control of fiscal powers.(2)

The aim of this Discussion Paper is to show why this doubt is unfounded and how borrowing powers can be devolved without putting sensible economic management at risk. We begin with borrowing and the ‘inflation bias’ problem. This follows a paper we wrote in May this year arguing that with two such different size states as Scotland and the rest of the UK the usual logic for fiscal constraints in a monetary union does not apply. Yet, even if that problem is solved, we then have the ‘bail-out bias’ problem, much feared in the Treasury and indeed Brussels and Frankfurt. The problem is that with two such different size states, there is both the incentive and the ability for the larger to bail out the smaller, whatever the political or legal constraints. The result is moral hazard (since Scotland would have an incentive to borrow imprudently).(3) This can only be tackled by addressing ‘the elephant in the room’ which is devolving more powers to other levels of government in the UK. These would be dramatic changes in UK constitutional arrangements indeed: but the current crisis of confidence in those arrangements revealed by the Scottish referendum could be the catalyst for real change.

1 The Scotland Act has a ceiling on borrowing for capital projects at £240mn per year and a cumulative ceiling of £2.2bn plus some borrowing capacity to smooth-over budget shortfalls which arise from forecast errors.
2 See North and Weingast (1989) on how the property and creditor rights which followed were perhaps the single most important reason why the industrial revolution happened in the UK and not elsewhere.
3 Von Hagen and Eichengreen (1996) describe two similar ways by which a common currency could be undermined: accommodating inflation by keeping interest rates lower than otherwise and bailing-out a government which could also lead to a monetary accommodation. We use the terms ‘inflation bias’ and ‘bail-out bias’ for simplicity.