Scotland's separatist legacy continues to haunt Europe

The people of Scotland have spoken and said ‘no’ to independence from the United Kingdom. In the immediate aftermath last week, there was a palpable sense of relief in financial markets. Market fear gauges settled down and risk trades were put back on. But it had a hollow ring to it. Market optimism has proven short-lived.

After years of closer integration in Europe, political fissures are starting to re-open again. The Scottish independence debate has been a rallying point for European separatist movements - especially in Spain, but in Italy and Belgium too. There is growing anger about Europe’s dire economic outlook. Unless some quick economic fixes come along soon, the future of the Eurozone and the euro are at stake.

Scotland will remain in the union of Britain, but the key issue for UK investors is whether Britain stays in the European Union. Political domination by ‘Westminster’ parties was at the heart of Scotland’s independence debate. Many UK voters feel the same way about autocratic and unaccountable EU bureaucracy in Brussels. These sentiments will come to a head at next year’s UK general election. A referendum on a future UK exit from the EU will be a key theme.

It is a trend unfolding in Europe too. At the national level, mainstream pro-EU parties are losing support to the political fringes thanks to growing anger over economic austerity and deepening voter distrust. At a regional level, it is leading to a shift in support for the pro-independence parties in a number of countries.

In Spain, attention continues to focus on the Catalan separatists who are calling for an independence referendum of their own in November. The poll is not recognized by the Spanish government but it could mark an important litmus test for growing disillusion with central government policies. Spain has been bowed under the yoke of tough fiscal austerity after the country opted for an EU bail-out in 2012.

Catalonia accounts for around a fifth of Spain’s economic output and tax revenues from the region make up a major slice of government finances. Spain’s ability to service its large public debt mountain – accounting for over 110% of GDP – would come under serious threat in the event of separation. It is no wonder that the central government is so opposed to giving Catalan independence a voice.

Spanish stocks and bonds were among Europe’s top performers in the wake of Scotland’s ‘No’ vote. But Spanish markets are not off the hook yet, especially if the Catalan referendum goes ahead in early November. It could still present Spanish and European markets with a nasty surprise.

The ‘No’ vote in Scotland does not signal the end of separatism in Europe – but it may change the rules of the game. Independence parties will be encouraged by how Scotland managed to secure pledges of new powers and extra economic concessions from the UK government on the eve of the referendum. This will not be lost on separatists in Spain, Northern Italy and in Belgium. Playing the independence card to extract more regional funding will simply deepen Europe’s budget mess.

There is a more worrying dimension. With the Eurozone economy overshadowed by recession and deflation, handicapped by austerity and high unemployment and saddled with crippling debts, there are still high odds that countries could dump the euro and leave EMU. Any country leaving EMU would spell out the deathnell for the single currency. It would unleash a domino effect among other countries.

At a time when Europe needs closer political, economic, monetary and fiscal co-operation to deal with the economic crisis, political cracks are becoming more apparent. Eurozone policymakers need to make a stand. A plan for structured reflation needs to be carefully crafted. Eurozone policy needs to be more cohesive and mutually inclusive for all economies on an equal footing.

For a start, Germany needs to drop its opposition to quantitative easing and give a free-rein to the European Central Bank to begin buying bonds to release a major new wave of cash into the economy. The scale of any QE programme needs to be at least three times greater than the one trillion euros plan recently hinted at by the ECB.

The Eurozone needs to abandon the Stability and Growth pact and loosen fiscal policy. France has implicitly already done this by suspending its budget deficit targets for two years. A mix of tax cuts and public investment spending initiatives should be channeled into promoting growth across the Eurozone.

The ECB should actively target getting inflation back to 2% and aim to boost domestic credit expansion. Eurozone bank should be forced to meet new lending targets. ECB interest rates should be pushed further into negative territory to force banks to lend.

The euro should be encouraged to weaken in order to boost export competitiveness and stimulate demand.

Europe has a choice – to let the economy sink or swim. Greater policy cohesion can stop the slide towards economic rot and the political disintegration that would accompany it. Europe needs to pull together rather than pull apart.