A Recipe For Disaster

That soundly Keynesian Nobel Laureate, Paul Krugman, writes:

Next week Scotland will hold a referendum on whether to leave the United Kingdom.

And polling suggests that support for independence has surged over the past few months, largely because pro-independence campaigners have managed to reduce the “fear factor” — that is, concern about the economic risks of going it alone.

At this point the outcome looks like a tossup.

Well, I have a message for the Scots: Be afraid, be very afraid. The risks of going it alone are huge.

You may think that Scotland can become another Canada, but it’s all too likely that it would end up becoming Spain without the sunshine.

Comparing Scotland with Canada seems, at first, pretty reasonable. After all, Canada, like Scotland, is a relatively small economy that does most of its trade with a much larger neighbor.

Also like Scotland, it is politically to the left of that giant neighbor. And what the Canadian example shows is that this can work.

Canada is prosperous, economically stable (although I worry about high household debt and what looks like a major housing bubble) and has successfully pursued policies well to the left of those south of the border: single-payer health insurance, more generous aid to the poor, higher overall taxation.

Does Canada pay any price for independence? Probably.

Labor productivity is only about three-quarters as high as it is in the United States, and some of the gap may reflect the small size of the Canadian market (yes, we have a free-trade agreement, but a lot of evidence shows that borders discourage trade all the same).

Still, you can argue that Canada is doing O.K.

But Canada has its own currency, which means that its government can’t run out of money, that it can bail out its own banks if necessary, and more.

An independent Scotland wouldn’t. And that makes a huge difference.

Could Scotland have its own currency? Maybe, although Scotland’s economy is even more tightly integrated with that of the rest of Britain than Canada’s is with the United States, so that trying to maintain a separate currency would be hard.

It’s a moot point, however: The Scottish independence movement has been very clear that it intends to keep the pound as the national currency.

And the combination of political independence with a shared currency is a recipe for disaster. Which is where the cautionary tale of Spain comes in.

If Spain and the other countries that gave up their own currencies to adopt the euro were part of a true federal system, with shared institutions of government, the recent economic history of Spain would have looked a lot like that of Florida.

Both economies experienced a huge housing boom between 2000 and 2007. Both saw that boom turn into a spectacular bust. Both suffered a sharp downturn as a result of that bust. In both places the slump meant a plunge in tax receipts and a surge in spending on unemployment benefits and other forms of aid.

Then, however, the paths diverged.

In Florida’s case, most of the fiscal burden of the slump fell not on the local government but on Washington, which continued to pay for the state’s Social Security and Medicare benefits, as well as for much of the increased aid to the unemployed.

There were large losses on housing loans, and many Florida banks failed, but many of the losses fell on federal lending agencies, while bank depositors were protected by federal insurance. You get the picture.

In effect, Florida received large-scale aid in its time of distress. Spain, by contrast, bore all the costs of the housing bust on its own.

The result was a fiscal crisis, made much worse by fears of a banking crisis that the Spanish government would be unable to manage, because it might literally run out of cash.

Spanish borrowing costs soared, and the government was forced into brutal austerity measures.

The result was a horrific depression — including youth unemployment above 50 percent — from which Spain has barely begun to recover.

And it wasn’t just Spain, it was all of southern Europe and more.

Even euro-area countries with sound finances, like Finland and the Netherlands, have suffered deep and prolonged slumps.

In short, everything that has happened in Europe since 2009 or so has demonstrated that sharing a currency without sharing a government is very dangerous.

In economics jargon, fiscal and banking integration are essential elements of an optimum currency area.

And an independent Scotland using Britain’s pound would be in even worse shape than euro countries, which at least have some say in how the European Central Bank is run.

I find it mind-boggling that Scotland would consider going down this path after all that has happened in the last few years.

If Scottish voters really believe that it’s safe to become a country without a currency, they have been badly misled.