￼Scotland’s currency – Hobson’s choice
- If Scotland leaves the UK, choice of currency is perhaps the most critical economic decision her government and people will face.
- The Scottish administration says it would like to keep the pound. All the major UK political parties say that if Scotland leaves the UK they would reject currency union. Why would the UK accept Scottish influence at the Bank of England when Scotland had chosen to leave?
- The Scottish Government would have four options; Scotland could continue to use Sterling informally; adopt the Euro; create a Scottish Pound pegged to Sterling; or issue its own floating, independent currency. All these alternatives are sub-optimal.
- Informal Sterling would have zero friction costs, no currency fluctuations with Scotland’s largest trading partner and little disruption. Yet it would bring increased economic and financial volatility and greater risk of shock. The Scottish economy is 9% of the UK economy. Scotland would have no monetary say at the Bank of England and none of its lender-of-last-resort protection. The Scottish economy is highly cyclical, for it depends on oil and financial services. Informal Sterling is a short-term fix with long-term dangers.
- The euro was once the Scottish administration’s choice. Yet the problems of divergent economic performance and unemployment rates across the highly divergent, sub-optimal currency area are a clear warning that membership is costly and difficult. Scottish membership of the eurozone would be akin to borrowing Sterling without the economic, trading, legal and cultural links.
- Scotland would have almost no say in setting monetary policy. It would be delusional to believe Scotland, with 1% of the EU’s population, could exert any meaningful influence. If a separated Scotland joined the EU, as the administration wishes, it might be compelled to adopt the euro as a condition precedent to accession.
- The Scottish pound might be distinct from sterling but pegged to it. Fixed exchange-rate mechanisms do not have a happy history. Fixing the Scottish pound to Sterling would compel Scotland, as a junior partner, to mirror UK fiscal policy willy-nilly. Fixing gives the illusion of sovereignty but the reality of following UK monetary policy without having any say.
- A floating Scottish pound would be the most attractive alternative to Sterling. It would hamper trade with the UK by adding frictional costs and exchange-rate risks but would give monetary and fiscal sovereignty. However, Scotland would need to be fiscally responsible or risk currency weakness, inflationary pressure and high borrowing costs. A floating Scottish pound must win credibility by fiscal responsibility, monetary discipline, economic dynamism and political stability. Scotland might fail to meet these criteria, since – oil or no oil – it would start with a heavy national debt and a wide fiscal gap represented by severe annual deficits.
- Scotland should keep Sterling. Those in favour of separation have not paid sufficient attention to the currency implications of leaving the UK.
- Maintaining a position as a full and equal partner in Sterling is overwhelmingly in Scotland’s interests, giving Scotland a say in monetary and regulatory decision making, allowing Scottish exports to the UK to move unhindered by frictional costs or currency fluctuations, sheltering Scotland’s large banking sector and steadying what may otherwise prove to be a highly volatile and depressionary economic future.
Currency is a separated Scotland’s key decision
Scotland and the rest of the UK, through 300 years of Union, proximity, common language, population exchange and similar culture, are very closely intertwined. Trade is a key factor in this network. Indeed, more than 70% of all Scottish exports go to the rest of the UK, dwarfing exports to Europe, the US and the rest of the world. The choice of currency is therefore critical, and perhaps the most critical decision, should Scotland separate from the UK.
The Scottish Government has oscillated on this issue, initially arguing that Scotland should join the Euro to benefit from ‘the arc of prosperity stretching from Ireland and other European countries.’
However, given the severe financial problems that impacted Ireland, Spain, Portugal and others inside the Eurozone and Iceland outside, the Scottish Government’s position morphed into declaring that a separated Scotland would keep the pound.
Understandably, all the major UK political parties have been clear that if Scotland leaves the UK they would reject currency union. Why would the rest of the UK accept Scottish influence at the Bank of England, when Scotland had chosen to leave? Scotland cannot reasonably expect to have its cake and eat it.
Given this rejection of formal currency union, the Scottish Government would be faced with four basic options. Scotland could continue to use Sterling informally. Secondly, it could adopt the Euro. Thirdly, it could either create a Scottish Pound or peg it to Sterling. Finally, it could adopt a policy of a free- floating, independent currency.
Under the current arrangements, the Bank of England is legally obliged to consider the optimal monetary response for the UK as a whole, including Scotland. Further, the entire banking system is protected by the Bank of England’s regulatory system and its ability to act as lender of last resort. This ability to intervene is not theoretical. The Bank played a major role in stabilising the UK banking system, and RBS and HBOS in particular, in their hour of need.
However, on separation this would no longer be the case. Monetary and regulatory policy would be set for the remainder of the UK. Scottish interests would no longer be the concern of the central bank. Scotland would effectively have ceded monetary authority to the Bank of England. It would not enjoy banking protection from the Bank of England as lender of last resort if Scotland chose to use Sterling informally. While it might be convenient, from a trading perspective, to use sterling informally, in reality such a policy would be fraught with danger in the long term.
In periods of economic calm such an arrangement would appear seamless. However, small shocks to the centre would be much more severe for those using the currency informally, without the support of the primary central bank. This would particularly be the case for Scotland, since the Scottish economy is potentially much more volatile than the rest of the UK as its dependence on oil (a highly cyclical sector) and financial services (banking assets, i.e. loans, are around 12x GDP currently and more than Iceland and Ireland in 2008) creates a potential instability.
Scotland’s population and GDP are just one-twelfth of the UK as a whole. Scotland, given its current assets and liabilities, cannot adopt Sterling informally without a substantial risk of asymmetric shocks. If Scotland chose the informal Sterling option there would be a number of advantages, namely zero friction costs no currency fluctuations with Scotland’s largest trading partner and little apparent disruption. These advantages, however, are minimal when compared with the implied increased economic and financial volatility and risk of shock. History is littered with the failure of informal currency unions. They are fine until they are not fine. Adopting such a policy is far from risk free. It is a short-term fix with long-term dangers.
The Scottish Government have cooled on their enthusiasm for joining the euro. The clear problems that membership has brought, in terms of divergent economic performance and unemployment rates across the sub-optimal currency area that is the eurozone, is a clear warning that membership is fraught with difficulty. Further, the problems that the eurozone faces are almost certainly not over, with countries increasingly forced to federalise, via such measures as banking union or financial transaction tax, in order to try to maintain the currency.
Scottish membership of the eurozone would be akin to borrowing Sterling without the economic, trading, legal and cultural links. Scotland would have virtually no say in the setting of monetary policy in what is a highly divergent union. Scotland’s population of 5.3m compares with an EU population of 503m. It would be delusional to believe Scotland could exert any meaningful influence. Monetary policy would not be set for the needs of Dumbarton when Dusseldorf and Dijon needed to be considered.
Indeed, the potential shocks from informal Sterling are clear for all to see in the eurozone. A rigid monetary policy across such a linguistically, culturally and developmentally distinct area has resulted in a much more divergent and divisive performance than sterling has achieved for the UK.
The EU is a pessimal currency area. In pessimal currency areas, there is insufficient convergence between the economic performances of different regions (in Europe, between the north and the south). The eight economic-convergence criteria for adoption of the euro laid down in the Treaty of Maastricht were abandoned when the European Commission, in its pre-changeover assessment, discovered that only Luxembourg complied with them. This abandonment guaranteed that the eurozone would be a pessimal currency area. In such areas, asymmetries of performance between efficient and inefficient regions are traditionally resolved by fiscal transfers that harm both the efficient donors, by way of undue cost, and the inefficient recipients, by way of removing the incentive to catch up and become efficient. The EU, however, lacks the means, legal, or democratic, to make significant fiscal transfers to a separated Scotland, and would in any event regard the poorer member-states as its first priority.
The charts below show both unemployment rates across the EU and employment growth over the last six years. While the core of the eurozone has relatively low rates of unemployment and sustainable employment growth, the same cannot be said for the periphery. If Scotland had adopted the euro when the leadership of the Scottish Government suggested that it should have done so, the consequences would have been disastrous given Scotland’s dependence on its very large banking system. It is probable that Scotland, in the eurozone, would have seen – and might yet see – the degree of unemployment, house price collapse and dislocation that Ireland has suffered.
Unemployment in the EU (%), May 2014
Employment growth 2007-2013 (% change)
Ironically, should Scotland secede from the UK it may be outwith Scotland’s control whether Scotland adopts the euro. A prerequisite for new members of the EU is agreement to join the euro within an agreed timeframe. New applicants are bound by the fiscal rules set out in the Maastricht Treaty, which demand much greater public-spending constraint than the Scottish Government proposes. Ireland is a recent example of a country which has been placed under direction of the EU troika in an attempt to normalise the public purse. Adoption of the euro does not come without fiscal constraint tight enough to reduce, not increase, Scotland’s fiscal independence and freedom of decision.
Herein lies the central paradox in the Scottish Government’s desire to be separated from her nearest European neighbour while remaining within the European Union. Thanks to the inward subsidies from the rest of the UK that would cease upon separation, the Scottish Government enjoys a far greater measure of autonomy in fiscal decision-making than it would have as a small country in the EU.
The optimistic view of the Scottish Government that Scotland would inherit all the UK’s opt-outs has not been encouraged by either the European Commission or a number of the member states. For example, euro membership is a non-negotiable condition for all EU members save the UK, Denmark and Sweden. Scotland’s negotiating hand would be weak in trying to avoid this outcome.
Indeed, the obligation upon a separated Scotland to adopt the euro is a demonstration of the central but unstated truth that the one option not available in the “independence” referendum is independence. There is some debate about what fraction of the laws of the member states originates from the EU. The Hansard Society has estimated 50%, the House of Commons Library 70% and the German Government 83%. If the German government is right, just two laws in 20 are first tabled in Holyrood, 1 in 20 in London, and 17 in 20 in the EU. What is clear is that, whichever statistic is taken as the benchmark, Scotland’s ability to initiate law would not be significantly changed after separation. Scotland would not be an independent country: for an independent country has the freedom to make its own laws.
What is more, with Scottish trade so dependent on the relationship with the UK, to adopt the euro, when it is probable that the rest of the UK would not, could only act as an impediment to trade, given exchange rate uncertainty and increased frictional costs.
It would make little sense for Scotland to adopt the euro. Scotland would have virtually no say on ECB monetary policy. Scotland’s trade with the rest of the UK is four and a half times greater than with the EU. Finally the record of the Euro to date is hardly inspiring.
A fixed Scottish pound
Scotland could set up its own currency, the Scottish pound. There would clearly be logistical issues and costs in doing this. The cost of transferring from national currencies to the euro was estimated at around £800m (or around £150 per head). A move to the Scottish pound could be conservatively assumed to cost a similar amount. There would be substantial ongoing costs as well, from accounting treatment, cross-border administration and exchange costs. These logistical concerns are clearly surmountable, although such a change would probably take a minimum of three or four years to implement. Given that, whatever the constitutional arrangements, Scotland and the rest of the UK are very closely linked and that Scottish trade is overwhelmingly with the rest of the UK, fixing the value of the Scottish pound to Sterling at least removes the exchange-rate risk.
However, fixed exchange-rate mechanisms do not have a happy history, as is clear from British experience within the ERM, or Argentina’s fix with the US dollar. The fix can be effective, in the long term, if there is a very high degree of economic convergence in the first place. Further, fixing of the Scottish pound to Sterling would compel Scotland, as the junior partner, to mirror fiscal policy in the larger entity. Fixing gives the illusion of sovereignty but the reality of copying the neighbour’s policy without having any say it. Here, too, separation would not deliver independence. Far from it.
Nor is the absence of monetary independence the only problem with a Scottish pound fixed to Sterling. If the fix fails, as fixes regularly do given the discipline required to maintain a fix, the consequences can be severe in terms of trade dislocation, asset valuations and internal wealth. At the extreme, Argentina has struggled to recover from the collapse of the peso’s convertibility with the US dollar some 15 years ago. A fixed Scottish pound sounds superficially attractive. In reality, it is not.
A floating Scottish pound
A separated Scotland would be a fairly small nation of 5.3m people, ranked 47th in the world in terms of GDP. Many countries of that scale (and smaller) adopt their own currencies. There is no doubt that Scotland could do so. The best option would be to retain Sterling; but, if Scotland were to abandon Sterling, a floating Scottish pound would be the next most attractive option.
A floating currency would hamper trade with the UK by adding additional frictional costs as well as exchange-rate risk. Yet at least it would give monetary and fiscal sovereignty to Scotland. However, a knife can be a dangerous weapon. If Scotland chose to adopt its own currency, it would need to act with greater fiscal responsibility than now or risk acute currency weakness and inflationary pressures.
The new floating Scottish pound would need to gain credibility with global markets. Credibility effectively means a fiscal and monetary responsibility, a degree of economic dynamism, and political and economic stability. It is far from certain that Scotland would meet these criteria quickly, especially as its starting fiscal position would be relatively weak, oil or no oil.
It is questionable whether the EU would be keen to promote the Scottish pound in a world where new applicants are expected to join the euro. If full partnership with sterling is not an option, in an ideal world the floating Scottish pound has some attractions, but these are offset by currency fluctuation with Scotland’s largest and closest trading partner. Smaller concerns include the currency risk many Scottish pensioners would face if they held Sterling-based UK-wide pension schemes.
Scotland should keep Sterling
Those in favour of separation have not paid sufficient attention to the implications of leaving the UK in terms of currency. Maintaining a position as a full and equal partner with Sterling is overwhelmingly in Scotland’s interests. This allows Scotland to be included in monetary and regulatory decision making. It allows Scottish exports to the UK to move unhindered by frictional costs or currency fluctuations. Also, as witnessed in the wake of the recent global credit shocks, it provides shelter for Scotland’s large banking sector. And it provides a calming influence on what may otherwise prove to be a highly volatile and depressionary path.
Advocates of separation have failed to address how maintaining partnership with Sterling can be achieved. After divorce the wife’s inheritance is normally lost.
None of the other options is palatable, least of all joining the eurozone, which, given the balance of trade and the negligible degree of influence Scotland would be able to exert over the ECB, makes little sense. Sadly, joining the euro could be forced on Scotland as part of the price of EU membership.