Considering a New Constitutional Settlement for Scotland
Studies in Fiscal Federalism and State–local Finance series
A possible reason for the decentralization of fiscal policy in the UK, particularly the macroeconomic stabilization function, is a consequence of the monetary union that exists within the UK. The so-called optimum currency area literature suggests a number of criteria that should be satisfied if a country or region relinquishes control over its monetary policy. If these criteria are not satisfied, or are only partly satisfied, then decentralized fiscal policy can act as a substitute. Of course, if the criteria are not satisfied this begs the question of whether Scotland should in fact be part of the UK monetary union. In this section we consider the implications of the optimum currency area literature for tax devolution, issues of macroeconomic risk sharing within a monetary union and the economic implications of Scotland leaving the UK monetary union. MONETARY UNION, TRADE CREATION AND EXCHANGE RATE BEHAVIOUR The logic of having a common currency between two regions is that by simultaneously reducing transaction costs, currency risk and the opacity of relative prices, it encourages trade. Glick and Rose (2002) estimate the effect of currency union membership on trade integration using a large data set of countries that have left currency unions. They find that trade integration with the remaining members falls by about one-half from the boosted level associated with monetary union in the year or so immediately following exit. Accordingly, if Scotland were to leave the UK monetary union, it might experience a large and rapid fall in its trade with its...