27/04/2015 06:15 BST | Updated 22/06/2015 06:59 BST

Scotland Can Run a Deficit - Here's How

Reading about Scotland's aging population and the dramatic fall in oil prices, you can almost hear the Unionists rubbing their hands with glee. Further, given the Institute for Fiscal Studies' recent forecast that an independent Scotland would be forced to run a budget deficit of around 9% of GDP, you might be forgiven for sharing some of the Unionist scepticism. After all, surely this would mean an independent Scotland would have to raise taxes, cut spending, or borrow to cover the ominous "black hole."

It was with these apocalyptic warnings in mind, the Scottish Labour's deputy leader, Kezia Dugdale, proclaimed that the SNP will be "signed up to massive spending cuts that would make even the Tories blush." This is quite a strong statement, but it just is not true.

Of course, predicting the future is not the most accurate of disciplines. Perhaps the SNP would shift to the right in an independent Scotland and decide to make these supposed "massive spending cuts." But, in theory, they wouldn't have to, nor would they need to raise taxes, and nor would be forced to "borrow" the money. These claims are predicated on the assumption that Scotland would not join the eurozone, but rather would have its own currency, like the rest of the UK.

In this scenario, what options would be available for Scotland to deal with this "funding" shortfall? The most realistic and practical option would be to do what the UK currently does when it runs a deficit: abstractly speaking, it issues whatever money it needs. In fact, simply by spending, in the very first place, it creates money. There are no cosmological, funding disasters waiting for the British government. Operationally, what currently happens is this: the treasury "prints" treasury bonds, which it sells to the market. This is called "borrowing," but it is simply an asset swap -- treasury bonds are as much money as pound sterling is. The Bank of England, then, is legally speaking in a position to buy the treasury bonds back from the market, which it does.

This is a convoluted way for the Bank of England (which can print as many pounds as it wants) to "fund" the treasury (which can print as many treasury bonds as it wants) -- a form of monetisation, if you will. This operational detail is the way it is, because EU law prohibits a nation's central bank from directly giving printed money to the treasury. To return to the conceptual level, the British government faces no solvency risk and no funding gap.

An independent Scotland would have a host of options available. It could use its newly created central bank to issue currency to the treasury, as it needs it. It could allow the treasury account at the central bank to run an unlimited overdraft. These options would violate European law, however, and so might be undesirable if Scotland were to attempt to join the EU. On the other hand, in line with the Maastricht Treaty, Scotland could licence its treasury to print some form of IOU (bonds, for example), which would be sold on the market, and then returned to its central bank -- exactly as Britain now does.

Whatever operational option an independent Scotland would choose, the conceptual details would be the same: a sovereign government cannot default and faces no financial constraints. Taxes would not have to be raised, and spending would not have to be cut, unless there was a political decision to do so based on the political will of the population.

As already noted, this argument relies on Scotland not joining the eurozone. If it were to do so, then it would not have the ability to issue currency as it sees fit. The worries about a funding gap would be valid, and, as in the case of Greece, the political will of the public would be largely irrelevant.