Little England: What’s Left If Scotland Leaves?

The crisis in the eurozone has exacerbated tensions between the monetary union’s northern and southern members, raising the specter that eurozone could splinter, with Greece possibly opting out.

But while the prospect of a shrinking of the eurozone appears more remote — with the ECB providing a safety net for solvent sovereigns, the worst of the euro crisis could well be behind us in 2013 — the United Kingdom took a small step closer to losing Scotland last week.

On October 15, British Prime Minister David Cameron and Scottish First Minister Alex Salmond announced that Scotland will hold a referendum on independence in October 2014.

That makes Scotland the only place in the European Union where a “divorce referendum” has been scheduled (although Catalonia may follow suit). But the Scottish Nationalists have recently vowed to keep the pound sterling as its currency after independence, at least for a while, just as the Catalans want to keep the euro.

Scottish independence would thus not spell the immediate end of the British currency union. In this sense, the pound sterling looks safer than the euro right now.

Opinion polls suggest that Scottish support for independence is running at just 30%, suggesting that the separatists will have a difficult time prevailing. But three factors could make the vote closer than current polls suggest.

First, after very little belt-tightening in the current fiscal year, the UK is heading for peak austerity in the next two fiscal years. Cuts in the structural deficit are scheduled to be almost four times as severe in 2013-14 and 2014-15 as in 2012-13.

Because Scotland depends more on government spending than England, some of these cuts may be particularly unpopular north of the border.

Second, the Conservative Party’s desire of the to distance the UK more strongly from the European Union (for instance, by opting out of the cooperation on many aspects of law and order policies) could be slightly less popular in Scotland than in England.

If the euro crisis does indeed fade over the course of 2013, the contrast between a UK reeling under additional austerity and a eurozone emerging from its own adjustment crisis could strengthen the hand of those in Scotland who want their nation to be an independent part of the European family.

Third, the Queen’s Golden Jubilee and the successful London 2012 Olympics have gave pro-UK sentiment a small boost this summer. That may not last until late 2014.

Small risks, but not zero

On balance, a British divorce is unlikely, though it is not impossible. If it were to happen, however, the impact on markets and the economy might be limited — especially if both parts remain full members of the European single market.

The example of the splintering of Czechoslovakia into the Czech Republic and Slovakia shows that somewhat similar countries can have a velvet divorce.

The risks are small, but not zero. The biggest risk could be a market perception that, after a British divorce, a “rump UK” could turn even more anti-EU than the UK is now.

Even the slightest perceived threat that a rump UK might eventually leave the European Union or could opt out of some major rules and institutions affecting the common market for services could be a major blow. Greater London has successfully turned itself into the services center for Europe and depends on guaranteed and fully free access to its major market.

A Scottish exit could also change the political scene in the remainder of the UK. Scotland is currently overrepresented in the UK parliament, and a majority Scottish MPs are from the centre-left. As a result, David Cameron’s Conservatives would find it much easier to win a majority of seats in future elections without Scotland.

In principle, this could make it easier to pursue pro-business policies. But it could also make it more difficult to keep at bay those within the Conservative Party who would like to leave the European Union — and thus put at risk the European Common Market, which the UK needs to sell its services.

It would be ironic if, after a possible fading to the euro crisis in 2013, markets start to discuss the risks to another union of nations in Europe — the United Kingdom. Fortunately, those risks appear to be contained at least for now.