The Implications of Scottish Independence

The country that gave us David Hume and Adam Smith could once again be a beacon of liberty, a case study in free minds and free markets.

The referendum polling stations are closed. By now, some three million Scots will have had their say on whether Scotland should be an independent country. There will be no exit polls and the votes will be counted by hand. But sometime between midnight and 2 a.m. Eastern Daylight Time, we should have a result.

The outcome is genuinely too close to call. The latest poll, published this morning by The Times of London, has the "Better Together" campaign up by four points, 52–48 percent, with four percent still undecided. But that, like most opinion polls in recent days, is well within the margin for error. An upset is still very possible.

But why would Scotland vote for independence, when 307 years of union with England has served them—and the United Kingdom as a whole—so well? What are the practical implications of a "Yes" vote? And which side should libertarians be on? These questions bear some examination, so read on if you want to know more.

Why would Scotland vote for independence?

First and foremost, it is worth remembering that Scotland existed as a (mostly) independent country for more than 800 years before its union with the Kingdom of England in 1707. And while the English often use "English" and "British" interchangeably, there has always existed a separate, distinctly Scottish sense of national and cultural identity. As long as Britannia ruled the waves, this identity was subsumed into a larger imperial project: "wider still and wider, shall thy bounds be set." But as Empire crumbled and Continental threats faded, so too did that sense of shared national purpose. Scottishness reasserted itself.

Natural resources played a role. Scottish nationalists claim that the vast majority of the oil and gas in the North Sea rightfully belongs to Scotland; "It's Scotland's Oil," as the campaign slogan goes. And, indeed, were the United Nations Convention on the Law of the Sea's "median line" approach to dividing territorial waters adopted, around 80 percent of the U.K.'s hydrocarbon production would fall under Scottish jurisdiction. Wind turbines may be all the rage nowadays, but black gold still has a powerful allure.

A third factor is political estrangement: Scotland has, for many years, been drifting away from the rest of the U.K. The decline of heavy industry hit Scotland hard, and Margaret Thatcher's Conservative government took most of the blame. Today, Conservatives hold more than half of England's parliamentary seats, and the U.K. as a whole has a Conservative-led government. But Scotland sends just one Conservative (from a total of 59 constituencies) to Westminster. The establishment of a Scottish Parliament, responsible for most domestic policies and around 60 percent of public spending north of the border, has only hastened this political detachment.

But perhaps the biggest factor driving the campaign for independence is something that isn't unique to Scotland—or even the UK—at all. And that is deep distrust of a political elite that is seen as venal, distant, and uninterested in the concerns of ordinary people. Scottish nationalism is benefitting from the same political forces boosting UKIP in England, the far right in France, the far left in Greece, and the tea party in the United States.

Alex Salmond, Scotland's nationalist first minister, has managed to frame this referendum as one in which the people are facing up against the political machine. The three Westminster parties—Labour, Liberal Democrat, and Conservative—haven't helped matters by running a cynical, lackluster campaign in which continued Union has seemed about as inspirational as a high-school economics textbook. The nationalists are selling freedom, protest, and self-determination; the unionists have fear and funding formulas on their side.

What are the implications if Scotland does vote for independence?

Most commentary on the prospects for an independent Scotland have focused on the economic adjustment that Scotland will have to make if it decides to go it alone. Given that it would start life with one of the highest levels of gross domestic product (GDP) per capita in the world, few doubt that Scotland could eventually thrive on its own. But there is equally little doubt that the transition would be a difficult one.

An independent Scotland's first challenge would be fiscal. The country's 2012-13 budget deficit would have been 8.3 percent of GDP, compared with 7.3 percent of GDP for the UK as a whole. And while British budget deficits are on a downward trajectory, and would be lower by the time Scotland officially became independent, there would still be an awkward fiscal hole to fill.

What's more, that 8.3 percent deficit figure depends on Scotland receiving significant North Sea oil and gas revenues. If such revenues are excluded, the deficit balloons to 14 percent of GDP. This matters, because the North Sea hydrocarbon industry has been in decline for some time, and such buoyant revenues may not last for long. When you consider that Alex Salmond has promised to use at least some of those revenues to create a sovereign wealth fund, and also accept that Scotland faces a more rapidly aging population (and correspondingly faster-rising welfare burdens) than the rest of the U.K., it is clear that things could get worse, fiscally speaking, before they get better.

Then there's the issue of debt. Britain's National Institute of Economic and Social Research has suggested that Scotland's share of the U.K. national debt would amount to around 81 percent of GDP. That is bad, but by no means unmanageable. But the issue is compounded in Scotland by uncertainties about what currency the country will use after independence.

The "Yes" campaign says Scotland will get a currency union with the rest of the U.K. And while all three Westminster parties, along with the Bank of England, have ruled that out during the referendum campaign, it remains a practical possibility. Given that any currency union would have to come with a fiscal pact placing strict constraints on Scotland's ability to run a budget deficit, and a banking union ensuring that Scotland's banks were closely supervised by the U.K.'s financial regulators in return for liquidity support from the Bank of England, it is unlikely that Scotland's borrowing costs would rise significantly in such a scenario. The downside is that it may take the imposition of unpopular austerity policies to keep an independent Scotland within the boundaries of a fiscal pact with the U.K. Left-leaning "Yes" voters who have been promised independence from a more conservative England might be in for a nasty surprise.

And that assumes an independent Scotland would get the currency union it desires. But let's imagine the three Westminster parties are true to their word, and Scotland is forced to adopt some other currency arrangement. The events of the last few years have made the euro a non-starter, and an independent Scotland wouldn't immediately be part of the European Union anyway. As a result, the "Yes" campaign has said that, first, they would refuse to take any share of the U.K.'s public debt if denied a currency union; and second, they would continue to use the pound sterling unilaterally, just as Panama, El Salvador, and Ecuador use the US dollar.

There are a couple of problems with this. For starters, refusing to accept a share of the U.K.'s public debt could be viewed as an effective default by the bond markets. That would mean an independent Scotland would be forced to borrow money at very high rates, or not at all. And whether that was the case or not, Scotland would still be forced to accumulate significant foreign exchange reserves to make "sterlingization" viable. Either of these prospects would require an independent Scotland to make deep and rapid cuts to public spending, so that they ran a budget surplus, rather than a deficit. Once again, this is not the future that independence supporters are voting for.

One more problem: under the "sterlingization" scenario—the unilateral use of pound sterling as currency—Scotland wouldn't have a central bank to provide lender-of-last-resort facilities to its banks, or to print money in the event that these banks needed to be bailed out. This is hardly idle speculation: Scotland's two biggest banks—the Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS)—almost collapsed in 2008; saving them required a £65bn bailout by the U.K. government. And that's just the tip of the iceberg: if you add in central bank liquidity support, government guarantees for wholesale borrowing, and promises to protect deposits, the government's total exposure ran to the hundreds of billions. The financial crisis would have sunk an independent Scotland—especially one with no control over its currency.

This point may be moot, of course, since Scotland's biggest banks would probably relocate their headquarters to London at the earliest opportunity if Scotland became independent and currency union with the U.K. did not come to pass. But this raises yet another unsavory possibility: bank deposits might follow the big banks south of the border, as people try to escape the financial uncertainty that independence could bring; this would force what remained of the banking sector in Scotland to rapidly shrink its balance sheet—that is, to scale back loans to businesses and households—sparking a severe credit crunch that would surely plunge Scotland into a painful recession. This doomsday scenario is by no means beyond the realm of possibility.

Do libertarians have anything to say on Scottish independence?

So far, this analysis has painted a pretty grim picture. And yet libertarians might read it and wonder whether a wealthy, independent country, which was forced to run a balanced budget, which couldn't print money, and which couldn't bail out its banks, would really be such a bad thing. In the long run, this may be quite astute: Most of the economic arguments against Scottish independence stem from the fact that they impose hard constraints on the size and scope of government, and from the libertarian perspective, that is no bad thing.

Indeed, independence may be the best thing that could possibly happen for the free market cause in Scotland. As things stand, any tax cuts, spending reductions, or market-oriented reforms to public services are seen as irredeemably foreign—something those dastardly Tories in England might force on Scotland, but never something the country would choose for itself. The existing, devolved Scottish administration spends money, but doesn't have responsibility for raising it. Every incentive it has points in the direction of more government, and those incentives matter.

Independence would change this dramatically: Scotland would be forced to restructure its public sector, not just to reduce costs in the short term, but also to deal with the prospect of an aging population. It would have to adopt the most business-friendly policies available to it, both to encourage enterprise at home and to bring in investment from overseas. And it would have to put in place measures to ensure the stability and sustainability of its financial sector, eliminating moral hazard in the process. Sterlingization could even end up being a boon to an independent Scotland. As my former colleagues at the Adam Smith Institute have pointed out, it could usher in a new era of competitive free banking, one in which the market—and not the central bank—spontaneously adjusts the supply of money to ensure macroeconomic stability. This is the stuff libertarian policy seminars are made of.

The effects of such a political turnaround would be felt beyond Scotland. Their most immediate impact would be on the rest of the U.K., which would be forced to up its game, but the lessons learned in an independent Scotland could end up traveling far and wide. The country that gave us David Hume and Adam Smith could once again be a beacon of liberty, a case study in free minds and free markets. Is that the most likely scenario? Perhaps not—and let there be no doubt, if Scotland votes for independence tonight, there might be a very rocky road ahead. But maybe, just maybe, it's worth the risk.