Scottish Independence and the Markets

11 09 2014

Jason Sorens has published a very thoughtful and well-informed blog post about how capital markets are responding to the threat of Scottish independence. The media has reported that the value of Scottish companies plunged when trading opened on Monday, largely in response to the shock YouGov poll over the weekend. Sorens points out that this so-called plunge primarily affected firms in particular sectors, with financial stocks taking a beating.

My reading of the situation is that the government of a large country is in a better position to bailout failed banks. When Scotland’s Royal Bank of Scotland collapsed, the UK government stepped in. It probably wouldn’t act as a lender of last resort to a bank in an independent Scotland, although British taxpayers did end up bailing out an Icelandic bank during the financial crisis. Of course, that raises the question of whether government bailouts of Too Big To Fail banks are indeed desirable. One could argue that the fragmentation of big countries into smaller ones could help to reduce moral hazard in the banking sector by eliminating the implicit guarantee that TBTF banks in large polities enjoy.

Big countries facilitate the pooling of risks between regions and firms. Such pooling has advantages, especially in the face of natural disasters such as the tsunami that affected north-eastern Japan in 2011. However, the pooling of risks facilitated by large states also creates moral hazard. Iceland, a country that was too small to bail out its banks, arguably had the best response to the 2008 financial crisis.

Pileus

What can we learn from capital markets about the likely consequences of Scottish independence? A trio of recent polls has shown the “Yes” side to have pulled roughly even with “No.” With momentum on their side, it’s not unthinkable at all that “Yes” will pull it out, resulting in the first secession from a Western democracy since Iceland withdrew from Danish union in 1944. Most American commentators, from Paul Krugman to Tyler Cowen, oppose Scottish independence and forecast economic disaster for the new country. Are they right?

Let’s look at the behavior of capital markets in Britain since these polls’ release to find out. First, let’s set the stage by looking at how betting markets price the probability of Scottish independence. Unfortunately, there are no nice InTrade-style charts for implicit probabilities anymore, at least not that I can access from the United States. From oddschecker.com, I am able to…

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