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Split ends

26 September 2014 By George Hay

How much devolution is enough? After Scotland voted to stay in the United Kingdom on Sept. 18, Prime Minister David Cameron pledged to honour pre-vote commitments to give the regions more power on tax-raising and spending. He should add the capacity to sell bonds.

Scotland or no Scotland, the hyper-centralised UK would benefit from devolution. Barely 5 percent of tax-raising is devolved on average, compared to 30 percent in Germany, according to University of Stirling research. That doesn’t mean it’s worth copying Berlin, though. German sub-central authorities have limited real autonomy: they raise only a few taxes locally, instead getting their share handed down from Berlin. Their powers to borrow are being reduced. A complicated system of fiscal transfers means that rich states hand over surpluses which help plug poorer neighbours’ deficits.

Canada, Switzerland and the United States provide a more relevant model. In those countries, so-called sub-sovereigns – for example, American states and cities – issue debt backed only by their own credit. Defaults do not cast a shadow on the sovereign’s own creditworthiness. If Edinburgh or Cardiff could access the capital markets directly, they could avoid the painful choice in tough times between harmful euro zone-style deficit restrictions and begging for help from London.

Of course, it could all go horribly awry. Some English politicians are already asserting that an English parliament should be given the same level of devolution as Edinburgh. But allowing a devo-maxed Scotland or a devolved English parliament to borrow on a sub-sovereign basis might not work, according to Angus Armstrong and Monique Ebell of the National Institute of Economic and Social Research.

In effect, these sub-sovereigns might be considered too big to fail. Investors would set low interest rates on Scottish debt because they expected the UK to come to the rescue in case of trouble up north. This “bailout bias” is probably justified. Central governments often soften at the prospect of a big regional bankruptcy. New York City was rescued in 1975, despite President Gerald Ford’s suggestion that the municipality could, as a local newspaper headline put it, “Drop dead.”

There are other problems. If an English parliament with control of 85 percent of the UK issued sub-sovereign debt, there might be “inflation bias.” Imprudent borrowing by the dominant member in a union could force monetary policy to be set to help it manage its debt, rather than to prevent the currency from being debased.

A more logical approach would be to split the UK into 12 regions with an average population of around 5 million people – nine English, plus Scotland, Wales and Northern Ireland. If all regions were roughly the same size it would reduce the scope for one big neighbor to bail them out, according to NIESR. Inflation bias could be handled via a British version of the U.S. Federal Reserve.

The BritFed could avoid the euro zone vortex encountered by the European Central Bank. It would need to make a rigid distinction between UK national debt, which would be eligible as collateral in its liquidity operations, and sub-sovereign debt, which would not.

The stumbling block is politics. At present Welsh, Scottish and Northern Irish funding is set by the controversial Barnett formula. Scotland and Northern Ireland currently get a good deal. Any new settlement would be controversial, and the Scots would consider a less generous one a betrayal. If every region was allowed to borrow and stand on its own two feet, most of the 12 regions wouldn’t have the tax base to maintain their current level of spending. Hence there would need to be some kind of equalisation grant to even things out – which could also cause resentment.

Finally, the 12 regions would have different expectations. Scots already decide over 50 percent of their expenditure, and many want all taxes and spending devolved under so-called “devo-max.” But other regions won’t all want this now. Another issue is the division of the cost of needs-based benefits and pensions.

Still, it needn’t be impossible to hammer out a more logical, decentralised UK. It would certainly be better than a lopsided one with a hugely devolved Scotland and resentful, hemmed-in English regions of equal size. But if it is to fly, London will need to conquer its fears about letting regions stand on their own two feet.

 

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