Real Devolution: The Power to Borrow - Reply
In our recent paper on devolution we argue that real power requires granting UK regions the ability to borrow in addition to tax and spending powers. In a blog post, Tony Yates suggested that this would in fact create the same mess as the Euro zone. He argues that granting borrowing powers to Scotland would lead to over-borrowing and limit the effectiveness of fiscal policy and risk sharing.
To be clear, the point of the paper was specifically not that borrowing powers should be devolved to Scotland alone. We explicitly recognise that within the political union of the United Kingdom this is likely to create moral hazard (outside of the United Kingdom we do not think the same points hold and we have argued against borrowing constraints in a monetary union involving two sovereign states of very different size). The point of the paper is that extending borrowing powers to regions across the whole of the UK can create responsible local decision making without the adverse consequences which arise when dealing with Scotland alone.
The substantive issue which Tony raises is whether granting borrowing powers to a devolved level of government necessarily leads to a Euro zone mess. In our view, it does not necessarily follow. Examples around the world indicate that a euro zone mess is not the inevitable outcome of devolved borrowing powers. There are successful federal countries with devolved/decentralized borrowing powers such as the United States, Canada and Switzerland that are not dogged by persistent over-borrowing at a regional level, nor has there ever been any threat of their domestic monetary unions collapsing.
Tony first points out that allowing local borrowing could create an incentive to over-borrow at the expense of the Federal government and monetary authority. We recognise two potential sources of incentives to over-borrow explicitly in our paper, and describe them as 'bail-out bias' and 'inflation bias'. We argue that the 'bail-out bias' is precisely why granting borrowing powers to Scotland within the Union would be problematic (as Scotland is small enough, so it can always be bailed-out). By contrast, an English parliament with borrowing powers could be too large and encourage monetary accommodation or an 'inflation bias' (as England would be 85% of the Union) and so is also problematic. 
Therefore, we asked what size of sub-national government could include the capability to borrow while avoiding these biases. There must be a way for a sub-national unit to fail to ensure market discipline, without disrupting essential public services. While there is already no regional representation on the MPC, one would also want the size of any sub-national government to be small enough to not indirectly influence macroeconomic policy.  This points toward relatively small and reasonably homogeneous units, hence our suggestion of regional level authorities. We think that the biases are an issue of design rather than a complete barrier to any devolution of borrowing power, and again emphasize that the US, Canada and Switzerland are positive examples here.
Tony’s second concern is that decentralization of borrowing powers could limit the effectiveness of fiscal policy, especially at the zero lower bound. While it is theoretically possible that devolving borrowing powers dilutes the effectiveness of fiscal policy, this is not obviously the case in practice. Fiscal space depends on many factors, for example debt levels and size of automatic stabilizers. Federal nations with devolved borrowing powers can still have powerful fiscal policy. IMF work suggests that G7 multipliers in times of large output gaps are larger in the US and Germany, two countries with devolved borrowing powers. Policy tools reserved for federal government are often particularly important in providing stimulus, such as VAT (often used as a stimulus tool) or welfare spending.
Tony’s third objection to devolution with borrowing powers is that it might weaken risk-sharing, presumably across regions. Again, we think that there are lessons to be learned from the experiences of the US, Canada and Switzerland on the one hand, and the Euro zone on the other. In the Euro zone, the lack of a unified social welfare system indeed inhibits risk-sharing. One of the common elements of successful federal states seems to be the centralisation of social welfare spending. Keeping pensions under the remit of the central government would go a long way towards risk-sharing across regions with differing age structures and longevity profiles. Switzerland and Canada both have pension systems at the federal level, while social security in the United States is also a federal program. Unemployment insurance is another programme that is well-suited to intra-regional risk sharing.
However, it is far from clear that we have full risk-sharing across the UK today. Allowing devolved regions to borrow on capital markets is itself another form of risk-sharing, which might actually complement existing risk-sharing mechanisms. The lesson to be learnt from last weekend’s referendum is that whatever risk-sharing is embodied in the Union might be endangered unless some real economic responsibility is devolved to the regions.
 This follows from analysis by von Hagen and Eichengreen (1996).
 We did not develop the English parliament argument, as this was not the issue at the time.
 We note that Bordo, et. al. (2011) and Kneebone (1994) describe how in the mid-1980s Ontario expanded its borrowing, and the Bank of Canada responded with tighter monetary policy – a deflationary bias, the reverse of the inflation bias described above!
 These regions do not currently have any administrative power and so this would be a substantial change in governance.
 See for example, IMF WP/12/286.
 The burden of locally financing pensions and healthcare for teachers, police and firefighters in cities with declining populations has played a key role in the bankruptcy of Detroit.