One Nation, No Currency

Michael St George April 23, 2013 1

Scotland’s currency options.

There are few more significant identifiers, economically or culturally, of a newly-independent nation than the currency it chooses and the associated monetary policy it proposes to pursue along with it. So do the currency and monetary options that seem to figure in the Scottish Nationalists’ planning for post-2014 independence support that criterion?

George Osborne

Anything but. Alex Salmond has been all over the place on this issue: he’s ranged from insisting (wrongly) that a post-independence Scotland would automatically retain a sterling currency union with the residual UK, to averring (wrongly) that it could somehow leverage the residual UK’s continuing membership of the EU to decide to join the euro. Every time, whatever his new position, his argument has been picked apart and its flaws exposed almost within hours. Each of the options the Nats are considering appears to contain within it an implication of sacrificing a large part of economic, fiscal or monetary independence soon after the illusion, if the vote goes the Nats’ way in September 2014, that it has been retrieved.

The four options have now been spelled out by the Treasury to accompany the speech which the Chancellor, George Osborne,Scottish currency delivered to a Scots business audience this morning. It’s worth summarising each one, and looking at the consequences.

Option 1 is Scotland continuing to use the £ sterling: but because Scotland would be a newly-independent state, that requires negotiating a formal currency agreement with the residual UK, in effect creating a formal currency union. That might not per se seem terribly different to what subsists now: but it is in fact very different, because it wouldn’t be within one polity where tax and fiscal policy is decided across the combined whole, but across two polities with (possibly markedly) differing tax, economic and fiscal policies.

Both states would be exposed to fiscal and financial developments in each other’s economies, but the disparity in relative size, competitiveness, economic power and risk between Scotland’s and the UK’s would mean the former’s latitude to pursue independent tax and fiscal policies being severely constrained by the fact of formal currency union. Inevitably, and  especially as formal currency union necessarily involves the Bank of England, as the UK’s central bank, functioning as lender of last resort to the Scottish economy, it would require oversight of them by the UK authorities.

Option 2 floated by Salmond appears to be a unilateral decision to continue to use sterling, but without a formal, negotiated agreement. This puts Scotland, in relation to the continuing UK,  in something akin to the same position as Ecuador or Panama in unilaterally adopting the US Dollar as their transactional medium of exchange (arguably not the happiest exemplars or models to have in mind in view of Scotland’s ill-fated Darien Expedition into Central and South America at the turn of the 18th century), but with scant, if any, influence over the currency’s monetary policy, including interest rates, which need take no account of the user’s own domestic economic circumstances.

With no ability to print money, any purely Scottish monetary authority would struggle to function as a provider of guarantees or a lender of last resort in the event of one or more Scottish commercial banks getting into difficulty. Compared with most small countries which have adopted this approach, Scotland’s economy is relatively complex, so the approach could put onerous constraints on monetary and fiscal policy, and on financial stability, limitations likely to become exacerbated in an economy with a sophisticated financial services industry like Edinburgh’s expertise in fund/wealth management.

Option 3 appears to be a totally new, totally independent, Scottish currency. This enables the newly-independent state to establish its own fiscal and monetary policy and exchange rate regime, but otherwise it looks fraught with downside risks. Ignoring the one-off costs of replacing sterling in circulation and setting up a central bank, there has to be a possibility of rapid, and economy-destabilising, money flows out of the country if firms and individuals preferred to hold assets in a more established currency, potentially depressing the economy through reduced velocity of circulation.


If the chosen exchange rate regime was for a floating currency, evidence suggests that exchange rate volatility would result, which could impose significant transactional and hedging costs on Scottish business, as well as adding to uncertainty: if on the other hand a fixed exchange rate to one of the world’s dominant reserve currencies was chosen, then the volatility could easily be transferred onto domestic wages and prices. In either case the challenge would have to be met by running a restrictive fiscal policy and budget surpluses: given the propensity of Scotland’s economy for high levels of state activity, spending and taxation, that looks unlikely to be electorally sustainable for very long.

Option 4 seems to be for the newly-independent Scotland to join the euro. Leaving aside the political difficulties of the Scotland’s EUforex-market1 and Eurozone approval and joining process, euro membership would not absolve the new state from the need to create Eurozone-framework institutions at member-state level, such as a central bank, with the disadvantages discussed above. However, beyond this is the difficulty of surmounting the reality that Scotland’s present economy differs significantly from those in the euro-area, being far more integrated with that of the UK than those of other Eurozone economies of comparable size.

Even more, though, the eurozone is transiting inexorably towards full fiscal, banking and political union, in effect run from the axis of Berlin and Brussels. Finally recognising that full currency union is unsustainable without full fiscal, economic and political union, the EU is rapidly moving to requiring that national budgets to be approved by the European Commission and/or Parliament before being submitted to national legislatures: that individual Eurozone economies accept the primacy of the EU fiscal framework, notably the Stability & Growth Pact limiting national budget deficits and the Fiscal Compact determining the nature and scope of national tax policies: and that national financial and banking sector policies reflect the framework of the Eurozone-wide banking union currently emerging.

As Germany’s Chancellor Angela Merkel put it, less than 48 hours ago, “euro-zone members must be prepared to cede control over certain policy domains to European institutions if the bloc is truly to overcome its debt crisis and win back foreign investors”. In effect, euro membership will virtually eliminate any meaningful autonomy in economic matters staying in Holyrood after independence. Salmond may crow that a Scotland joining the euro means a Scotland no longer subservient to Westminster in economic and monetary policy – what he omits, though, is that it means subservience to Berlin and Brussels instead.

Everyone will have their own view on the political advisability, or otherwise, of Scotland leaving the United Kingdom. What, though, seems indisputable, is that Salmond’s claims, that a Yes vote in September 2014 means economic independence as well as political independence, are so much hot air.

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