Sunday, 2 March 2014

Scotland's Currency Options

There has been much talk of the four currency options for an independent Scotland. Much that I have seen suggests that not everyone understands what the options are, let alone what advantages and disadvantages each has. Perhaps, leaving aside political issues for the moment, I might be allowed to outline them.

1. A sterling currency union means that both the UK and Scotland continue to use the pound by agreement. Between two economies of such unequal size as Scotland and the UK such an arrangement has little to recommend it except familiarity, (which was not enough to preserve the currency union of The Czech Republic and Slovakia after their political split.)
  • It is not possible for a single central bank to operate two monetary policies. Market forces would oblige the central bank to pursue the monetary interests of the larger partner, even if political factors did not.
  • Likewise neither partner could pursue an independent fiscal policy, because each government's borrowing would increase the common money supply. Agreement would be required.
  • The UK would therefore have to cede a degree of its own monetary independence to Scotland. It has previously resisted doing this for the Eurozone, which is a much bigger market.
  • An additional disadvantage would be each partner taking on an obligation to underwrite the finances of the other without the multinational burden sharing that is possible within the Eurozone.
  • This is the option that the UK has ruled out. There are good economic reasons for ruling it out and no advantages for the UK that would come near to compensating for the loss of independence.

2. Informal use of sterling by Scotland means Scotland continuing to use the pound without the UK's agreement. This is the kind of arrangement used by Ecuador and Panama in respect of the dollar. It could not be prevented by the UK. It would avoid the introduction of exchange costs for trade within Britain, but is far from meaning that nothing would really change. Effectively it would take most of the so-called 'levers' of economic influence out of the hands of the Scottish government.
  • It would not allow Scotland to create its own money supply.
  • It would prevent a Scottish central bank from operating a meaningful monetary policy.
  • Although this would also remove the need for UK government agreement of Scotland's fiscal policy, the same sort of constraints would be imposed instead by the need to obtain sterling through trade etc.
  • It would remove the guarantee provided by the UK underwriting Scottish finances. This would imply a higher government borrowing rate for Scotland.

Thus neither formal nor informal currency sharing would allow a great deal of economic flexibility to the Scottish government.

Both formal and informal currency sharing would remove from the Scottish government's economic armoury the possibility of adjusting its exchange rate with the UK in order to absorb any imbalances that might develop.

3. A new Scottish currency is the only other option likely to be immediately available to an independent Scotland.
  • This has a lot of short term costs and risks, including the introduction of exchange costs with the UK.
  • However a more serious problem would be the need for the new currency to be underwritten by a Scottish government with no track record of debt management and which has incautiously flirted several times with the option of not taking on its share of UK National Debt. Possible lenders will remember perfectly well that a lot of the UK debt was incurred in bailing out Scottish banks and threats to walk away from responsibility for that debt can only raise the cost of borrowing by an independent Scotland.
  • It might take some time to reassure foreign exchange markets that the new currency was 'hard', (i.e. it can be trusted to hold its value.)
  • The new currency would also be a 'petrocurrency', (i.e. volatile and vulnerable to oil shocks.)

4. Joining the Eurozone is not a immediate option, because the entry conditions require two years' stable management of the domestic currency, a qualification which a Scottish government would lack. There may or may not be separate problems associated with Scotland's admission to the EU itself.
  • It needs to be borne in mind that the Eurozone is just another currency union and that Scotland would be even less influential within this much larger zone than it would be in a sterling zone.
  • Effectively monetary policy would be determined centrally and fiscal policy would be subject to the EU's Stability Pact.
  • Even this has not been enough to preserve stability in the Eurozone of late and it seems likely that more political integration within the zone will be required in order to cement the stabilisation of the Euro as a currency.

Those, very briefly are the options. None of them are as advantageous as the present arrangement, but of course the present arrangement cannot be combined with independence.