Fisher Investments Editorial Staff
Geopolitics, Developed Markets

Alba Gu BrĂ th!

By, 10/16/2012

History came to Edinburgh on Monday, when UK Prime Minister David Cameron and Scottish First Minister Alex Salmond signed a landmark agreement allowing Scotland to hold a referendum on independence in 2014.

For Scotland, independence would be the final step in the devolution process that began in 1998, when the Scottish Parliament was established and granted legislative authority over policy areas, known as “devolved matters.” Wales and Northern Ireland are also devolved, though which policy areas are devolved varies among the constituent countries. For example, health care, education, environment and agriculture, among others, are devolved in all three, but the judiciary is devolved only in Scotland and Northern Ireland. But national defense, foreign affairs and fiscal, economic and monetary policies are national or “reserved matters,” in the vernacular.

Devolved governments also don’t issue debt or collect taxes. Instead, the UK uses a block grant system to allocate funding to each constituent. The financing model, dubbed the Barnett Formula, grants each country a share of total UK revenue proportionate to its population and the amount England spends on areas devolved elsewhere. Whatever England spends on corresponding functions in 2011-2014, Scotland will receive 10.03%, Wales will receive 5.79% and Northern Ireland will receive 3.45%. The devolved governments may allocate these funds as they see fit—Scotland, for example has chosen to abolish university tuition and prescription drug fees. This system covers about 50-60% of total spending in each constituent country. The remaining spending, on items like social security, is centralized.

Devolution has worked out largely well for the UK. For one, the Welsh, Scots and Northern Irish get more say on local policies. That’s no small victory. These nations have relatively few seats in Parliament—in the House of Commons, Northern Ireland has 18, Wales has 40, Scotland has 59 and England has 533. Before devolution, English lawmakers effectively determined policy in Wales, Scotland and Northern Ireland, which caused a fair share of local discontent.

Using the Barnett Formula and keeping debt issuance centralized has also helped the UK avoid regional debt problems seen in Spain. Constituent countries must set policy according to the resources they have—the money Scotland spends subsidizing higher education and prescription drugs is money it can’t spend on transport, the environment, agriculture and the like. Additionally, unlike Spain, the UK doesn’t use a regional fiscal transfer system aimed at correcting economic imbalances, so independence in Scotland isn’t the heated issue it is in Catalonia. If anything, many suspect Scotland has a pretty sweet deal at the moment, given its social security spending needs likely outweigh tax revenue generated inside its borders—the UK government estimates Scotland’s social benefits and pensions bill would be double tax revenue from North Sea oil interests (assuming Scotland would get all North Sea oil rights in the independence settlement—a big if).

Scotland has another advantage: A very sound currency, with monetary policy that accounts for its economic needs. Scottish leaders have suggested an independent Scotland would still use ye olde British pound rather than join the euro. But that means Scotland would delegate monetary policymaking to the BOE, which may not have Scottish representatives. BOE policymakers thus might very well act without prejudice to Scotland’s situation, potentially causing some rather painful dislocations up north. The eurozone has taught us what can happen when countries with varying economic competitiveness try to share currency and monetary policy—there’s no guarantee a “sterling area” would work any better. Also, should Scotland eventually need central bank intervention, the BOE might not be keen on using British taxpayers’ money to purchase the sovereign debt of an independent Scotland. This may help explain why a mere one-third of Scots support independence at the moment.

Yet, as much as Scotland has benefited from devolution, as history buffs and Braveheart fans can attest, it also has a proud tradition of independence—self-determination is a powerful force. Thus, in two years, Scottish voters will be asked whether they wish to grant their government a mandate to negotiate independence with UK leaders.

Negotiate is the key operative—a “yes” vote doesn’t mean instant independence. Scottish and UK leaders would have to sort out a host of issues, including: Who gets the North Sea oil? How much of the UK’s national debt does Scotland assume? How would a Scottish defense force break off from the UK military—will Scotland keep Royal aircraft and ships? Which government assumes liability for the RBS bailout? Negotiations on these and other issues could take a very, very long time.

But the referendum absolutely bears watching. An independent Scotland would change the political and economic landscape in the British Isles considerably. For example, if Scotland goes, Wales might follow—with England taking an even greater share of the UK parliament, Welsh leaders might decide independence is their only option if they want to have any say in reserved matters. Or Wales and Northern Ireland might push to reform the House of Lords to give each constituent country equal representation, similar to the US Senate. This could radically alter UK lawmaking (though the potential impact will depend on whether the House of Lords becomes an elected chamber). And if Scotland stays, its government likely pushes for further devolution, including the ability to set and collect taxes. If that happens, similar efforts could follow in Wales and Northern Ireland, altering the UK’s fiscal policy.

First though, get ready for two years of heated referendum campaigning.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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