Guy Lodge of IPPR and I have an article in today’s Scotsman, about the right lessons to learn for devolution finance from the problems of sub-state borrowing in southern Europe. The article can be found here. Below is the original copy we filed, with some hyperlinks added.
DEBT AND FISCAL DEVOLUTION: LEARNING FROM CLUB MED
It was inevitable that the eurozone crisis would cast a shadow over the debates about Scotland’s constitutional future. The SNP have already been forced to rethink their commitment to take an independent Scotland into the euro, opting instead to stick with sterling for the foreseeable future. Developments in Italy and Spain mean the spotlight has now turned on those who support further enhancing the powers of the Scottish Parliament instead of independence. For many the case for handing Scotland greater tax and borrowing powers has been badly damaged by the sight of Valencia, Catalonia and most lately Andalucia – Spain’s indebted autonomous communities – queuing up for bail-outs from the Spanish government. Does the UK really want to replicate the situation in Italy where the central government has been forced to take over the finances of a fiscally autonomous but bankrupt Sicily?
The Treasury – which has just ended a consultation on Scottish borrowing – is clearly looking hard at Club Med’s problems. It no doubt thinks the UK has dodged a bullet by ensuring that devolved governments cannot run up similar debts. But that would be to draw the wrong lesson, getting both the politics and the economics wrong.
In fact, there are two lessons that can be better learned from southern Europe’s current travails. The first is that hard budget constraints – that devolved budgets cannot be open to politically convenient top-ups from central government – are vital. The problem with the Spanish regime for financing the autonomous communities is that regional and central state finances are hopelessly entangled, which means that bailouts are regarded as being on offer, and (outside the Basque Country) powers to set tax rates have never been used to depart from the rates set years ago before the taxes were devolved. Spanish fiscal devolution has involved a slow, incremental deconcentration of tax powers, without ever fully separating the finances or tax powers of each government. Worse, overlaps in functions and political choices by the central government may have driven up borrowing. Catalonia regularly complains that the central state has deliberately under-invested in central government infrastructure functions in Catalonia, using the money saved (much of it generated by Catalan taxpayers) to spend elsewhere. Consequently some Catalan regional spending is needed to fill that gap (it is therefore over-simplistic to regard the problem as ‘regional overspending’ – the central state is also partly responsible for the perilous state of the autonomous communities’ finances).
This means fiscal devolution must also involve disentangling devolved and UK finances. Devolved governments must be both equipped and required to fund devolved services using their own resources, whether those come from devolved taxes or from redistributive grants. There can be no rushing to London for help if devolved governments make a mess of things. Devolved governments must be free to use their fiscal powers to shape both the public services they provide and the wider economic environment – but also bear the burden of things going wrong if that is what happens. Fiscal responsibility must go hand in hand with fiscal power. Both must be meaningful, and be regarded as such.
And they can be reconciled with the interest of equity by using redistributive grants to enable all parts of the UK to have similar levels of public services – if that is what they want. The second lesson relates to borrowing – whether by issuing bonds or other instruments, or from the UK Government. Borrowing powers need to go hand in hand with tax powers; they are necessary not just for ‘prudential’ borrowing to fund capital projects (the need for which has now been accepted by the UK Government in the Scotland Act 2012). They are also needed to help balance the risks that come with raising even part of a government’s own spending. That implies a much larger borrowing power than the UK Government has been willing to concede for Scotland up to now. The question is not just how much a devolved government should be able to borrow, but also how it does so. Should it have direct access to the bond markets? Should that access be controlled in any way? Will the UK Government be obliged to bail out a devolved government if it gets into difficulty – and if so how will that affect interest rates for the borrower, or impose restraints on the devolved government? There is a tension here – even a contradiction – between enforcing a hard budget constraint (which implies handing over powers and risks) and safeguarding the interests of the sovereign government.
The best answer to this question is that government borrowing is necessary if a government levies taxes, that borrowing inevitably involves risks, and those risks include an implicit assumption that the UK Government would bail out a devolved government at risk of default. What is important is to find ways to manage those risks. The UK Government should set a small number of clear, high-level criteria for devolved borrowing, including an overall ceiling that incorporates both ‘prudential’ borrowing and that which is need to manage fluctuations in tax revenues. It should not interest itself in the purpose of borrowing or the reasons for it, but simply ensure that the UK Government’s vital interest of ensuring macro-economic stability and maintaining overall control of UK level public finances. Micro-managing devolved governments’ finance does not serve those objectives – and gets in the way of the political priority of making devolution work, and the other economic one of making sure the hard budget constraint is indeed hard. It’s also pointless, as the devolved governments are so small compared to the UK as a whole that the scope for them seriously to undermine the
UK’s international financial standing is very limited. The Treasury’s tendency to control-freakery is more likely to undermine UK interests by preventing devolution from delivering what voters want, than to protect the integrity of the Union.
Managing regional level finance is not easy. The Spanish and Italian examples show how it can go quite seriously wrong. But it’s telling that there are no such problems with more fiscally decentralised federal systems like Switzerland, Canada or the United States. What all those systems have is real fiscal responsibility at state, cantonal or provincial level, with separate public finances, tax bases and effective hard budget constraints. Those are better systems to learn lessons from than the ‘make-do-and-hope’ approach of some of the southern European countries.
DEVOLUTION MATTERS 
“For many the case for handing Scotland greater tax and borrowing powers has been badly damaged by the sight of Valencia, Catalonia and most lately Andalucia – Spain’s indebted autonomous communities – queuing up for bail-outs from the Spanish government.”
Am I correct in saying that Catalonia is a net contributor (by 16bn Euros) to the central government, and that the latter is proposing cuts of 40bn Euros to Catalonia?
Hasn’t the Catalan Parliament just passed a motion to hold an independence referendum after the coming elections in November?
I missed this post when it first came out, but I thought I should still comment on it.
I’m a Canadian government official who’s been following the devolution process in the UK with some fascination (occasionally horrified) for some time. I have to register my (near) complete agreement with Alan Trench here.
Judging by the Canadian experience — with so decentralized a federal structure that its provinces are fiscally dominant and face no meaningful constraints on either provincial borrowing or taxation policy autonomy — I’m not convinced that “hard budget constraints” are all that relevant, if only because they’re difficult (if not impossible) to actually make “hard”, given the vexing “time consistency” problem associated with most professions of fiscal virtue. (“Lord, make me fiscally virtuous — but not yet.”)
More to the point, evidence from the premiums provinces pay on their cost of funds (Canadian provinces access domestic and international debt markets readily and often) suggests that the debt markets have priced in a very strong implicit guarantee of provincial borrowing: for example, the premium they pay over the federal cost of borrowing is typically very small: 30 or 40 basis points — i.e. the magnitude of a liquidity premium rather than a risk premium.
I regularly make presentations to visiting foreign delegations that come to explore Canada’s rather extreme model of devolution. I typically tell them that if (as is indeed the case for the most part) our provinces behave with great fiscal rectitude, it’s not because of any controls on their borrowing from the central government (these are non-existent), or even because of the fiscal discipline imposed by market borrowing costs, but simply because a province that racks up higher deficits and resulting debt service costs is simply going to have to increase taxes (at no small political cost to itself) if it is to avoid severe cuts in the very program spending that generated the deficits in the first place.
In short, from our experience, the link between devolved autonomy over taxation and over borrowing is and must be one of political accountability for fiscal, budgetary and taxation policies pursued. This — and not any command-and-control or external constraints — is what lies at the heart of effective mechanisms for ensuring responsible fiscal behaviour at the level of devolved governments.