Scottish independence: the question of currency

Strictly speaking, a country only has rights over its currency within its own boundaries. Any country may use as its own currency a portion of any other country’s money supply that is available externally. Panama, for example, uses the US dollar, as did Zimbabwe for some years.

There is, therefore, nothing to stop an independent Scotland using the pound sterling, the yen or the Zambian kwacha except the difficulty of getting hold of enough money supply to serve all her economic needs.

However, a problem that arises for countries without their own currency is that they cannot create additional money supply for themselves and so they must run a balance of payments surplus (acquire more money supply) before they can expand their economies other than by the short term expedient of running down their foreign currency reserves.

In passing, it should be noted that Scottish banks already need to back their note issue with sterling on a 1:1 basis, but it is unlikely that this licensing arrangement would survive independence, so all notes circulating thereafter in a Scotland still using sterling would probably have to be Bank of England notes. Of course, the great bulk of money supply is not notes anyway, but bank deposits, etc. The principle is essentially the same.

A second problem is that there is absolutely no obligation on the country of origin of the currency to take account of the needs of the unofficial user when setting its own monetary policy. This effectively enforces fiscal rectitude on the secondary user, which cannot simply ‘print’ money, unlike a country that has its own currency. Quite often this is the reason for using a foreign currency: a country which, for political reasons, finds it hard to control its spending and thus risks severe inflation can force itself to ration the available money supply if it can’t make any more.

So, whilst no-one could force an independent Scotland to abandon sterling, a consequence of retaining it would be allowing monetary policy to be dictated by the UK government and restricting fiscal deficits to the size of available new sterling supplies. That’s not very independent, frankly. In fact, it’s probably less independent than the present degree of Scottish devolution.

On the other hand, starting a new currency involves a lot of irrecoverable sunk costs. These may be one-off, but they still need to be financed. And borrowing in the new currency would initially have to be very cautious, because otherwise its forex value could be volatile.

I don’t want to get started on the consequences of adopting the Euro. No, seriously, don’t ask.

Scotland, the pound and the euro

Tobermory, Mull, Scotland

After independence, either of these options effectively involves Scotland using a foreign currency as the domestic currency.

Europhiles will tell you that the Euro is the domestic currency of all its members. This is theoretically true and for all practical purposes absurd. In practice, the Euro is a DMark-lite and the German economy is hugely more influential in determining its Forex value, monetary policy and ultimately fiscal policy than any other member.

A country that uses a foreign currency as its domestic currency forfeits the right to determine its own monetary policy. It is not possible to set a monetary policy for several countries at once unless those countries form an Optimum Currency Area (OCA). This means (inter alia) that there must be no significant obstacles to labour and capital mobility between the members, there should be wage flexibility between the members, and the members have more or less synchronised business cycles. Where these conditions do not obtain, there will be a need for a mechanism of fiscal transfers between the members to mitigate the damage that an inappropriate exchange rate and monetary policy will do to the weaker economies.

At present, the Eurozone lacks a number of features that enable an OCA to function effectively. Hence every few years we have a Eurozone crisis from which one or more weaker economies emerge worse off.

Scotland could be considered to be more of an OCA with the rest of the UK than with the EU. Language is always an important barrier to labour mobility; another is the portability of pension rights. Currently, Scotland has both of these links with the UK, with which it also does almost four times as much trade as it does with the EU. The UK business cycle is regularly out of step with the EU business cycle because, unlike almost all other EU member states, the UK does more trade outside the EU than within it.

As a member of the UK, Scotland has been marginally disadvantaged by using the same currency as the rest of the UK but has received compensating fiscal transfers. This has avoided excessive unemployment or depression of wages compared to the richer south.

(To forestall political objections to the foregoing sentence, let me point out the simple fact that it is less cost-efficient to buy and sell in low population densities, which is much more typical of Scotland than England).

Luxembourg

Once it is a non-member of the UK, such fiscal flows to Scotland would presumably cease, unless a transitional agreement with the UK were to be negotiated. Moreover, there would be no obligation upon the UK to consider the impact of its monetary policy upon Scotland. Continuing to use the pound after independence in these circumstances (without the above mitigations) would probably lead to additional downward pressure on Scottish wages and employment, but not so great as the impact of joining the Euro. (Consider the impact of the latter upon Greece, Italy, and Spain for example.)

I have suggested elsewhere that the UK single market could survive Scottish independence. This would be to Scotland’s considerable advantage. However, the UK single market could not survive Scottish membership of the EU single market, which requires ring-fencing. In the latter circumstance, Scotland, like any new EU member (not to be confused with existing members who have exemptions) would be required to join the Euro. So not only would there be a hard border with England, but there would also be a change of currency at the border. This is a really bad idea unless you want Scotland to be poor.

Scotland and the Pound

I received an abusive comment on Quora , which maintained that the pound was as much Scotland’s as England’s. Please permit me to clarify:

Yes, the pound is as much Scotland’s as it is England’s, which is to say, not at all. The pound is the currency of the United Kingdom, the laws of which include a currency union created by and subject to that same set of United Kingdom laws.

Monetary policy within the UK is the responsibility of the Bank of England under a series of Acts of the UK Parliament. For example, though the Bank of England has a legal monopoly of the note issue, Scottish commercial banks are allowed to issue notes under licence. Under the 2009 Banking Act, they must hold sufficient reserve assets (Bank of England notes or gold) to maintain the value of their notes in the event of commercial failure. This is because, strictly speaking, Scottish notes are not legal tender but promissory notes.

Just as withdrawal from the EU would leave the UK no longer subject to EU law, withdrawal from the United Kingdom would leave Scotland no longer subject to UK law, which includes the laws governing the currency union and the laws governing the note issue.

An independent Scottish government could choose to issue a currency called pounds, but it could not choose to issue UK pounds since it would no longer be part of the UK. (There is no prospect of Scotland being recognised as the continuing state as opposed to the ten times larger population from which it would have withdrawn, which would continue to be governed by UK law.) The Scottish pound would thereafter become, domestically and internationally, a separate currency from the UK pound. The exchange values of the two currencies could diverge.

Regarding sterling, Scotland would have two options:

1. To ask the rUK to continue the currency union, which was what the then Chancellor specifically ruled out in 2014, or


2. To use UK sterling (now a foreign currency) within Scotland as Panama currently uses the US dollar. This places monetary policy in the hands of the issuer of the currency, that is to say, the rUK.

The EU Referendum and Scotland

I am disturbed by the glibness of the prevailing assumption that if Scotland votes to remain in the European Union and the rest of the UK votes to leave, it will be appropriate to hold a second independence referendum.

Some time ago I pointed to the damage inflicted upon inward investment to Quebec by the determination of defeated separatists to hold a referendum re-run. Political instability deters investment no matter how often the SNP claims otherwise. Since the European polls are evenly balanced and the Scottish polls not much clearer, we now have the worst of all possible worlds.

The fallacy of the assumption that Scottish enthusiasm for the EU will lead to the break-up of the UK lies in the conflation of these two questions. Just because a voter favours remaining in the EU it does not follow that he or she would vote for independence rather than see that wish thwarted.

So far as I am aware, no-one is being asked at the moment whether they would prefer to be in the EU or the UK. Even that would be a fraudulent question, since Scotland is not a current EU member and would not be accepted as such even if the UK withdrew. A breakaway Scotland would still be a new applicant for EU membership, as was repeatedly explained during the independence referendum.

Therefore the actual question should be: Would you like to leave the UK and take a chance that our subsequent application to join the EU would not be vetoed by Spain and other member states anxious to avoid giving encouragement to restless ethnic minorities?

Does it make any sense at all to erect a border against our largest export market, the UK, in order to retain free trade with much smaller markets in the EU?

Is it remotely credible that the UK would leave the EU in a bid to cut immigration and then allow freedom of travel across the border with an EU Scotland?

Bearing in mind the chaos of the currency question during the independence referendum, does anyone seriously believe the UK would exit the EU and allow Scotland to take sterling straight back in?

EU rules require new members to join the Eurozone. How many people really want to join a system that has strangled economic growth, plunged its poorer members into impossible debt and obliged its richer members to bail them out?

Simply to state these issues is to show the foolishness of the assumption noted in my first paragraph. I do worry however that Europhiles will harp upon this refrain until more and more people in Scotland assume that it must be true.

Scottish Monetary Policy

If Scotland continues to use sterling despite no longer being part of a currency union, we will have no choice but to accept whatever monetary policy the UK decides upon.  There are 58 million in the UK and 5 million of us.  They will have no more reason to take account of a foreign Scotland when determining their monetary policy than the USA has to take account of Panama when determining theirs.

Deduct the forty odd Scottish Labour seats and the chances are that the next UK government is Conservative.  They will implement Conservative monetary policy in the UK and that policy will apply in Scotland because Scotland will not have its own monetary policy.

Perversely this means that, so long as Salmond’s Currency Plan B remains the use of sterling without agreement,  voting 'yes' in the referendum results in the imposition of a Tory government's monetary policy in Scotland.

Perhaps this is what he means when he promises that Scotland will get what it votes for.

No-one can stop us!

"No-one can stop us using the pound!"

That is true. No-one could stop us using the dollar or the yen either, if we chose to do so. It just wouldn't be smart. Neither would using the pound outside the UK currency union.

No-one can stop Panama and Ecuador using the dollar, so they do use it. But the dollar is a foreign currency, controlled by a foreign country. These two Latin American countries allow the USA to enforce fiscal and monetary discipline upon them because they can't easily do it themselves. They have to generate trade surpluses in order to accumulate domestic spending power. Their governments are not masters of their own economies.

So if Scotland wants to wrest control of monetary policy away from London only to hand it straight back again, this time with no influence over it whatsoever, then yes, no-one can stop us.

On the other hand, good luck generating the trade surplus needed to pay for the promised fairer society after the financial services industry has been forced to move south of the border in order to stay in the same jurisdiction as its lender of last resort. Most Scottish financial products are exported to the UK.

Good luck obtaining a fair share of The Bank of England's foreign currency reserves after you've refused to take a fair share of the UK national debt.

Good luck finding people to purchase Scottish government bonds when you've shown yourself likely to default whenever you don't get what you want.

But we can always console ourselves with the thought that no-one could stop us!

Scottish Referendum:Currency Plan B (for Broke?)

This is the text of my letter,  published in The Falkirk Herald last Thursday:

"It's Scotland's pound and we're keeping it," they say. We are still being treated like children who do not understand economics.

The pound is the currency of the union. It is not Scotland's pound, nor is it England's, Wales' or Northern Ireland's pound. Scotland proposes leaving the union. You cannot divorce and expect to retain the joint account. When you're single again you must establish your own account and pay your own way.

It's no good repeatedly telling your ex-partners that it's somehow in their interest to continue underwriting your debts; after the 2008 crisis they won't believe you.

If Scotland used the pound unilaterally we would have to accumulate pounds by trade, since our government could not create for itself an increased supply of a foreign currency. Failure to generate a trade surplus would thus preclude the blithely promised fairer society. You might want it, but you can't have it if you can't pay for it.

Without a central bank, borrowing would become more expensive, especially if the Scottish government followed through on its reckless threat to throw over responsibility for its share of the UK National Debt. Remember a Scottish Chancellor under a Scottish Prime Minister recently increased that debt to rescue The Royal Bank of Scotland. No-one lends cheaply to those perceived as defaulters.

Loss of financial sector jobs could easily run into tens of thousands, reducing tax revenues, increasing the Scottish government's need to borrow and raising interest rates still further.

Using sterling without agreement has costs. It's not just a matter of thumbing our noses at the rest of the UK and saying we'll do as we like.

Scotland and self-determination

If you confuse nationalism with patriotism, you are also likely to confuse self-determination with separation. Scotland was not conquered; a bankrupt country chose voluntary union because it desperately needed access to the financial resources of its more prosperous neighbour.

Those resources again rescued the country from bankruptcy as recently as 2008, when the UK raised £46 billion to save RBS.

That UK government was led by a Scottish Prime Minister and a Scottish Chancellor. Far from failing Scotland, it enlarged the national debt on Scotland's behalf. SNP leaders now threaten not to pay our share.

The sum needed to bail out a single Scottish bank contrasts with the half billion a year transaction costs the UK may suffer should it decline to share its currency.

It seems that, unlike the separatists, the UK government can do sums.

Currency unions are like joint accounts

I really did not intend to devote so much space on my blog to the economics of Scottish independence.  I feel obliged to do so because political spin doctors have been engaging overdrive in an apparent attempt to obscure the issues and reduce popular understanding. I have no problem with people making an informed choice.  I do have a problem with people being misled.

In my letter published in yesterday's Falkirk Herald I used the same metaphor that I have previously used on this blog.  When I compare a currency union to the joint bank account of a married couple, I do not of course mean to suggest that they are the same thing, merely that they have a number of helpful similarities.

Not many non-economists have a clear grasp of the nature of currency unions.  Indeed the history of the Eurozone suggests that either a fairly substantial number of economists did not understand these principles either, or that political confidence overwhelmed economic objections.  The disparate economies that were enclosed in the straitjacket of the common currency were simply not sufficiently closely aligned.  A certain number of conjuring tricks were employed to make the figures look reasonably convergent in the qualifying year, but everyone should have realised that the important issue was not the statistics but the underlying reality.

A decade of growth camouflaged the problem; it did not make it go away.  The long rolling series of near defaults was always going to happen. The fact is, that  two divergent macroeconomic policies cannot be accommodated within a single currency zone.

Non-economists will, I hope, find the problem simplified by my analogy.  Like our divorcing couple separating their bank accounts in order to prevent one party from spending the other's money, two countries each need their own currency in order to operate any approximation to an independent monetary policy.  The Eurozone went for the joint account first and  loveless political marriage seems bound to follow if they will not reconsider their mistake.

Scotland is a tenth of the size of the UK and any currency union between the two would never result in her being able to underwrite UK debts.  The UK would have no partners in underwriting Scotland.  In return for taking on unlimited liability the UK is offered freedom from exchange costs that at most would amount to a little more than 1% of what it cost the UK to bail out RBS alone.  Can anyone seriously claim that represents a good deal for the UK?

There is no economic justification for divorcing London in order to marry Berlin.  The Eurozone is going to tighten its political integration.  Unofficial use of sterling can only be a short term stratagem since it would deprive Scotland of any effective monetary policy at all. 

Independence means a new Scottish currency.  There.  It wasn't so hard to say it after all.

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.

Less Heat, More Light, Please.

Since last Thursday the currency issues in the independence debate have been, perhaps deliberately, obscured by emotional language. As I've said, we really do need to distinguish between a formal currency union and the informal use of the UK pound by an independent Scotland.

A currency union's price is financial interdependence because each member state may create new money. In the Eurozone we see a practical example. The short version of the lesson is: when some members overspend, those which do not overspend have no effective choice but to bail out their partners or risk the collapse of the whole system. 

The Eurozone is now being compelled by economics to pursue exactly the sort of political integration that is the opposite of the objectives of the 'Yes' campaign. 

The failure of the UK to agree a currency union with Scotland would not lead to exchange costs for UK businesses. Such costs would in fact result from a Scottish decision to adopt a currency other than sterling, as I discussed on 13 February.

Informal use of the UK pound by Scotland would be unlikely to lead to much greater financial flexibility however, since we could only obtain more money supply by means of a balance of payments surplus / net inward investment.

Quoting my article of 7 November 2013, "My judgement would be that a Scottish currency is the least of the evils, but that it requires preparation to start yesterday and much statesmanship from Scottish ministers."

Why no Plan B?

Let me try again to clarify matters affecting the currency of an independent Scotland. Two issues are still being confused: on the one hand the right of Scotland to continue to use the pound and on the other the continuation of the present currency union.

The Eurozone is an example of a currency union of separate states. All of the partners have the right to create new money; this means that none of them is financially independent and a financial crisis in Greece inevitably drags in the Germans who have no crisis of their own.

UK ministers and opposition have indicated that they find the prospect of a similar currency union arrangement with an independent Scotland unattractive because it would mean the UK losing financial independence just as Germany has.  The Scottish Government reply seems to be, 'They can't stop us using sterling.' This is true, but it does not mean that we can force the UK to accept a currency union.

An independent country may use any currency it likes, including a foreign currency, subject only to its ability to get hold of enough of that currency to meet its needs. For example Ecuador uses the US dollar. The US could not prevent this, even if it wished to do so.

The point being confused in the independence debate is that a country in Ecuador’s position cannot create US dollars. Were it to attempt to do so, the US would simply decline to recognise them as legal tender. This means that Ecuador's only monetary policy option is the monetary policy of the US, which takes no account of Ecuador when setting it. For the same reason Ecuador must operate under tight fiscal discipline.

If an independent Scotland wants to use the UK pound then we cannot be prevented from doing so, but in the absence of a currency union with the UK we could not create UK pounds since we should no longer be part of the UK. We should be in a similar position to Ecuador, with no monetary and little fiscal autonomy.

We could of course create Scottish pounds, but we could not force either the UK or the international exchanges to accept these at parity with the UK pound. The most likely outcome would be the circulation of both currencies inside Scotland, though it might be some time before the Scottish pound was enthusiastically accepted externally.

Scotland's Future

Imagine that you are a banker. (If you are not already a banker this may be hard, but please try.) On a certain day you have appointments with each of a newly divorced couple, both of whom require loans to help them on their separate ways. The divorce has been acrimonious and reported in the press. Partner A has repeatedly threatened to accept no responsibility for the debts incurred on their joint account, not even those incurred in making purchases on his own behalf. He has now changed his mind. Partner B has gone on settling all debts as usual. Bearing in mind that, as a banker, your first responsibility is the security of your own funds, to which of the couple will you be more inclined to lend?

Amongst all the sound and fury surrounding the launch of the White Paper 'Scotland's Future', one figure has received surprisingly little attention. It is projected that in the first year of independence the Scottish Government will require to borrow £4.4 billion.

This is the same Scottish Government that:

1. has repeatedly threatened not to accept a share of the UK national debt,
2. denies Scotland's responsibility for the actions of a Scottish Chancellor in raising the UK national debt in order to bail out failing Scottish banks,
3. is already spending beyond its means,
4. has promised yet more spending in pursuit of a fairer society,
5. is about to destroy Trident-related jobs by the thousand,
6. is committed to a currency union and thus will not be able to set its own monetary policy.

Are you still imagining that you are a banker? You are not of course a Scottish banker, since the major Scottish banks are no longer Scottish owned. You are a foreigner and this Scottish Government is asking you for £4.4 billion. This year.  Alternatively you could lend to the RUK government which also needs a loan.

Bearing in mind that, as a banker, your first responsibility is the security of your own funds, what will you do?

Scotland and The National Debt

Alex Salmond has once again (19 November) threatened that non-compliance by the rest of the UK with his demands to 'share' sterling and The Bank of England after Scottish independence could lead to Scotland refusing to accept its share of the UK national debt. I realise that this is campaign rhetoric. It is nevertheless misguided.

The markets are listening.  They want to know what to do if they have to deal with an independent Scotland in the future.  The more likely a ‘Yes’ vote becomes the more they will trawl through the backlog of such remarks for guidance on future Scottish financial policies.  They will not like what they find.

Let us be clear. There are three important reasons why this demand is misguided.

1. Firstly, sterling is not an asset it is a national currency.  A currency is a claim on goods and services within an economy; it is not itself a good or a service. I have already explained in an earlier article the problems that are likely to face an independent Scotland that seeks to share a currency with its much larger neighbour.
2. Secondly, The Bank of England is the official banker to the UK government and an instrument of UK monetary policy.   Although its terms of reference are laid down by UK law, its independence from direct UK government control has been guaranteed since 1997.   Scotland is seeking to leave the UK. SNP ministers claim to want control of the economic levers for themselves. In what way would this purpose be served by 'sharing' an institution that does not take orders from government?
3. Thirdly, and most importantly, governments must never suggest defaulting on debt.  They must not imply it, or hint at it, or say anything that may be misinterpreted as an implication or a hint.  Everything that a First Minister or Finance Minister says is market sensitive.

The reason is that governments always need to borrow money.  Even governments running a surplus on the budget need to borrow money, because, just like you and me, the timing of their income does not coincide with the timing of their payments.  People who lend money to governments are sensitive to anything that makes them the tiniest bit afraid they might not get it back.  Every such unguarded remark could add half a per cent or so the Scottish Government's borrowing costs after independence.

We may end up with a Scottish currency whether we like it or not, for reasons outlined in my earlier article.  In any case, foreigners will have to hold Scottish paper with confidence.  The more suggestions there are that Scottish ministers don’t understand the markets and are careless or glib with financial pronouncements, the more reluctant foreigners will be to hold Scottish currency or bonds.  Scottish interest rates will have to rise to compensate for this perceived increase of risk.  In consequence, Scottish investment will become more expensive and therefore Scottish economic growth will fall. 

Is a point or two in the opinion polls today worth a point or two on the Scottish government's borrowing rate for years to come? 

Scotland's Currency in a Customs Union

In an earlier article I suggested that a currency union does not make market forces go away, it simply diverts them into other channels. It so happens that a customs union is already diverting these market forces into other channels, so there is a shortage of alternative channels left available.

A customs union means that partner economies have no tariff barriers between themselves but have a common external tariff towards non-members, thus in principle creating a single domestic market. Let us assume that Scotland is admitted to (or remains a member of) the EU and that the rest of the UK remains in the EU after 2017. The EU is a customs union.

Whilst the EU single market is not perfect, the RUK and Scottish markets have long been one. Not only are goods and services traded freely between the countries of the UK but workers and capital also move freely.

A larger domestic market enables firms to produce on a larger scale and so make efficiency savings. The result is faster economic progress than the member economies could have achieved separately. However for poorer areas, membership of a customs union comes with a downside. If they can, most people will want to sell goods and labour in places where they receive more for them. This means that for trade between richer and poorer economies to continue in the long term, one or more of three possible adjustments must be made.

1. The simplest adjustment is for the less developed economy to run a balance of payments deficit with the more developed. The more developed extends credit to the less developed, effectively transferring funds to finance the continued purchase of its own exports. But a customs union has a single market. Scotland currently has no more meaningful a balance of payments with RUK than Yorkshire has with Lancashire.
2. The second possible adjustment is for the poorer country to devalue its currency relative to that of the richer. This makes the poorer country’s exports cheaper and more attractive in the richer country, whilst the latter’s exports become prohibitively expensive in the former. But within a currency union, Scotland’s pound could not be devalued against RUK’s, nor could Scotland's Euro be devalued against Germany's any more than Greece's Euro can be.
3. The third possible adjustment is for employment and national income in the less developed economy to fall to a level consistent with its relative inefficiency. Because this depresses the internal economy rather than adjusting the economy's external relationships, it is far more painful and ideally should be a last resort, allowing the two external adjustments to take as much of the strain caused by the imbalance as possible. Unfortunately inside a combined customs and currency union this third adjustment is not the last resort, it is the only resort.

Taken as a whole, the Scottish economy is somewhat less developed than that of England. This is an observation, not a criticism. It is structurally less diverse and hence more vulnerable to swings in the markets for its major industries, a phenomenon exacerbated by a disproportionately large (and currently weak) financial sector and the temporary as well as highly volatile effects of North Sea oil.

The discrepancy between the Scottish and English economies is of course as nothing compared to that between the Greek and German economies. Yet Scotland still needs to take note of what has happened to Greece inside a customs and currency union.

Currently within the UK, the old industrial areas are poorer than the south-east of England, but economies of scale created by our currency and customs unions raise national income sufficiently for compensatory transfers from richer to poorer areas to be politically acceptable. It would be difficult to make such transfers to Scotland after independence.

In summary, I am not sanguine about any of the currency options facing an independent Scotland. Nevertheless, in the event of independence, one of the options must be selected. My judgement would be that a Scottish currency is the least of the evils, but that it requires preparation to start yesterday and much statesmanship from Scottish ministers.

Sharing a Currency

A modern economy is based on achieving efficiency by specialisation and then exchanging produce with other specialists. A currency facilitates exchanges because it gets round all the problems of having to barter. You might therefore think that in principle it would be good to share a currency with as many as possible of those with whom you hope to trade. The problem is that a currency has to perform other functions too. For example it measures value and value is not the same everywhere and to everyone.

The Euro was the EU's response to the failure of attempts to fix exchange rates between EU members by means of the so-called 'Snake'. The Snake was overwhelmed by market forces. Politicians believed that this could not happen to a currency union. The truth is that a currency union does not make the market forces go away, it simply diverts them into other channels.

The Euro is not a currency in which all members are equal. For most of the Eurozone's members it is effectively a foreign currency except for the absence of exchange costs. Market forces do not give equal weight to small economies and big economies. This means that all along the Euro has been in reality a Deutschmark-lite.

If you use a foreign currency you also accept a foreign country’s monetary policy, whether it is appropriate for your economy or not. You cannot simply demand that the foreign country takes account of your needs if they conflict with its own. 

Inappropriately low Euro interest rates before 2008 therefore fuelled unsustainable credit expansion and property booms in several weaker economies than Germany that needed more monetary discipline. This contributed to a series of crises as soon as the currency union came under serious stress. Meanwhile for Germany the Euro offered an artificially lowered exchange rate that allowed faster export-led economic growth than was justified by German costs of production.

Just like the Euro in Ireland or Greece, the pound will be effectively a foreign currency for an independent Scotland whether or not a Sterling Area is agreed and whether or not parity of status is claimed by politicians.  RUK is about ten times the size of Scotland.   An independent Scotland using the pound will have to accept what will essentially be the RUK's monetary policy.

The claim that an independent Scotland would become entitled to a seat on the Bank of England's Monetary Policy Committee is misleading at best. The independent status of the Bank (since 1997) precludes any government exercising influence over the MPC, which comprises Bank executives and independent economists. The UK Treasury representative who attends its meetings is not allowed to vote. Who could imagine that a Scottish government representative, even if allowed to attend, could have a greater role?

Scotland's Currency

A long time ago, when the earth was young and dinosaurs still stalked the uplands of Sliabh Mannan, I trained as an economist. I say this in order to justify a limited intervention in the independence debate. Mine is an economic commentary, not a political one. Substituting politics for economics was what led Europe into the débacle of its single currency and, since this precedent should not be emulated by the wise, I wish to examine the question of a currency for Scotland.

Any modern economy requires a currency. The fundamental choice is between one of your own and someone else's. Until recently, no-one was seriously suggesting that Scotland should adopt its own. In theory, creating your own currency is the only way to attempt monetary independence, since sharing a currency involves sharing sovereignty over monetary policy. In practice however, no open economy has full monetary sovereignty anyway, since the foreign exchange markets are too large for governments to control. It would not be impossible for Scotland to adopt its own currency. It would be expensive and it might be risky.

For a small and trade-dependent economy such as Scotland's, a new currency might seem an undesirable course, since it automatically introduces barriers to trade in the form of exchange costs. Unnecessary barriers to trade reduce the competitiveness of an economy and with it the standard of living in the country. To introduce barriers to trade with England, Scotland's principal market, would seem a bad way to start on an attempt to increase prosperity.

A new currency would also be vulnerable to exchange rate fluctuations. It would be more vulnerable than sterling to oil price changes, since oil is more significant in the context of the Scottish economy than that of the UK. An erratic currency handicaps trade by forcing buyers and sellers to protect themselves against unpredictable exchange rate changes.

The currency might well be discounted against sterling until traders became confident of its stability (and this discount would be greatly increased should the Scottish Government carry through its 2013 threat to refuse its share of the UK National Debt). It seems not unlikely that Scottish interest rates would have to rise relative to those of the residual UK in order to defend the Scottish currency. Investment would thus be adversely affected.

In all probability an independent Scotland would therefore be obliged to use an existing currency. Given that the majority of Scottish trade would be with England it would make most sense to use the pound. The only viable alternative would be the Euro, which is currently enduring an unresolved long term crisis, rather like a householder who pushes filler into the cracks in his walls and resolutely refuses to inquire why they have cracks in the first place.

In a future article I shall return to the economic implications of a shared currency.