Beware of Economic Gales

Winter gales are nothing new on Sliabh Mannan. On those parts of the moor where the soil is heavy clay, tree roots tend to spread along the surface rather than penetrate downwards. It is never a great surprise when I go out to walk my dog after a gale to find some woodland giant blown over intact, with its root system now forming a vertical wall at the windward end.

Having no great depth of root might be seen as a metaphor for the Scottish economy. We are heavily dependent upon a fairly restricted range of industries, notably oil and finance. When times are good for these industries they can be very good. Basking in the glow of high employment and government revenues from profits taxes, it is tempting for non-economists to be seduced by propaganda assuring them that Scotland is one of the richest countries in the world and could be a Utopian society if only we were independent.

Following the financial crash of 2008 we now see the oil price crash of 2014-15 and the announcement of redundancies in the oil industry. Nevertheless the Scottish government continues to demand a form of Devo-Max under which we should become dependent upon our own highly volatile taxation resources rather than insulated from economic gales by a continuation of the present UK funding arrangements.

It seems to me that members of the Scottish government would benefit from taking a trip out to Sliabh Mannan and learning the lesson of our fallen trees.

We have all lost

How very thin the crust of civilisation is. There we were, patronising the mediaevalism of other cultures, confident that we had progressed beyond all that nonsense.

Then along comes another false messiah, denying every inconvenient fact and promising a naively simplistic road to (earthly) paradise. Lo and behold, masses of our fellow citizens (on both sides) promptly revert to tribalism. The English backlash is no prettier than the Anglophobia that provoked it.

Perhaps someone will remind me when was the last time an arbitrary line drawn on a map, leaving minorities numbering hundreds of thousands on each 'wrong' side, helped solve rather than create problems?

Or the last time that emphasising what divides people rather than what unites them led to peace and prosperity?

Whoever wins on Thursday, we have all lost already.

Goodbye Primrose Path

If you see a friend walking towards the edge of a cliff whilst playing a game of blind man's buff, what do you do? Call out a warning, I expect.

You might well be surprised and upset when your friend shouts back, "Scaremonger!" and continues to walk forward.

"No really, there's a cliff!" you call.

"Disgraceful negativism!" he replies, sticking his fingers in his ears and starting to hum "La,la,la - can't hear you!"

Separatists amongst Scots seem to believe that as long as you dress up market forces as pantomime villains and hang a sign round their necks labelling them 'English Tory Scares' you may safely ignore them. Economic laws do not apply in the land of Braveheart.

But isn't it really going a bit far to respond to relocation decisions from major financial institutions by continuing to shout 'Scaremonger'?

Just what counts as economic evidence if capital flight does not?

People who don't trust what might happen at the ballot box are voting with their wallets.

It might be a good time to remove the blindfold and take a look ahead.

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.

Scottish Independence - Shouting is not Truth

In economic forecasting, it is standard practice to project a range of possible outcomes, from the best to the worst case with the most likely somewhere in between.

In the independence debate, the separatists have consistently claimed that the best case scenario is what will actually happen. They portray this as 'making a positive case'.

Should any opponent point out that the most likely outcome is actually considerably worse than than this, he is accused of 'negative campaigning', whilst anyone who has the temerity to suggest that the worst case is every bit as likely as the best case is guilty of 'disgraceful scaremongering'.

The tone of the debate would be improved if everyone accepted that in the real world things do not always go as we wish them to go and other people do not necessarily agree with our view of what is in their best interests. Any sensible person hopes for the best but prepares for the worst.

It is a statement of the obvious that the single minded pursuit of a new prize may very well lose us prizes that we have already won.

Divided we fall

Given the unpalatable nature of reality, separatists tend to deny economics and appeal to raw emotion. This tactic is effective but divisive.

The bullying conspiracy against Scotland that has been conjured up in the popular imagination loses no potency by virtue of being nothing but market forces dressed up as a pantomime villain. Tribalism is immune to reason.

Since a large minority will remain passionately opposed to either outcome of this referendum, divisions will be slow to heal. In a future crisis we shall be tempted not to pull together but to blame our neighbours who foolishly voted the wrong way.

We should have learned from history that a common legacy of unrealistic expectations is social conflict and a search for scapegoats. Inside or outside the UK we are going to suffer for the disunity that has been so recklessly fomented.

Read My Lips ...

I vaguely remember learning about the South Sea Bubble of the 18th century. Apparently back then there was such enthusiasm for floating new joint stock companies that people would even buy shares in 'a company to do something, nobody to know what.'

We are far less gullible today. I mean, no-one would vote for 'a country to have a currency, nobody to know what,' or 'a country to be in the EU, nobody to know how,' would they?

In the news this week:

• The Yes campaign's response to the refusal by all three UK parties and the UK Treasury to contemplate a currency union with Scotland is not to devise an alternative currency scheme. Instead they claim that nobody except the Yes campaign can do sums properly.

• They also point out that we may be dragged out of the European Union against our will by the 2017 in/out referendum. Safer to vote for independence and be sure, eh?

Since you couldn't make it up, it's just as well we don't have to.

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.

Bailing Out Other Countries

Some people perceive double standards between the UK's bailout of Ireland in 2010 and its disinclination to accept a sterling currency union that would include an obligation to bail out an independent Scotland.

The economic logic is actually straightforward. Ireland belongs to the Eurozone. In 2010 the UK contributed about £7b of an EU rescue package of around £85b, in the process extracting the concession that it would not have to bail out Eurozone members again.

In a prospective sterling currency union of two, the whole of the burden of bailing out one partner would fall upon the other. There would be no obligation on EU members to contribute, any more than they contributed to the £46b UK bailout of RBS.

There is one other big reason for the UK not wanting to share sterling. The Bank of England cannot operate two monetary policies. For example, it could not simultaneously create a stimulus in Scotland and apply restraint in England. Money would simply flow between the two.

It is Scotland that is proposing to leave the UK, not vice versa. There are ten times as many UK Citizens outside Scotland as inside. There is no reason for them to let us take away with us a piece of their economic independence.

The more things change ...

I hope that amongst those whose enthusiasm for Scottish independence has more than a passing resemblance to support for a football team, some will take time to consider the issues before they vote.  I won't be holding my breath.

Those who make out a reasoned case are capable of entering into reasoned argument.  Those who behave like football fans are not.  I speak as a football fan.  There is no one who will ever convince me of the superior merit of an alternative team to my own.  I was born to support my team and it never occurs to me to waver. Whether we are bottom of the league and regularly thrashed or masters of all we survey, we are who we are.  That's why I refer to my team as 'we' and, as everyone knows, 'we' are permanently in opposition to 'them'.

I can afford to be so illogical because, fortunately, my livelihood is not at stake in matters of football. In matters of politics mixed with economics the issues are, hard though it may be to accept this, more weighty.

These are some of the issues that I wish to see resolved:

1) It is claimed that Scotland needs independence in order to lay hold of the important levers by which our economy is to be directed.  It is simultaneously claimed that we shall immediately hand back all of the monetary levers and a large proportion of the fiscal levers to The Bank of England and the rest of the UK. The Governor of the Bank of England seems to have confirmed this. Question: remind me again what is the point?

2) It is claimed that a currency union is in the interests of the rest of the UK because of the way it will simplify trade. Problem: it also makes the RUK responsible for the debts of the Scottish government, banks and public institutions and gives the Scottish government a say in UK monetary and fiscal policy.  There are quite good reasons for their refusing to accept this. Please explain to me why they will do it.

3) It is claimed that we shall automatically continue as members of the European Union, despite the claims to the contrary of, amongst others, the President of the European Commission and the government of Spain.  Bad news; this has to be unanimously agreed by EU members and the Spanish have a vote.

4) It is claimed that we could be added to the existing membership of the EU without having to accept the rules normally applied to new members, such as signing up to the Euro and the Schengen free travel area and that for some reason we would be entitled to a share of the UK's current budget rebate. Problem: in return for all their concessions, we are giving the other members what, exactly?

5) It is claimed that we shall continue to enjoy a common travel area with the rest of the UK, whilst adopting a radically different immigration policy from them.  Question: exactly how do we stop them setting up border checkpoints to enforce their immigration policy?  How much would consequent delays cost us?

6) It is claimed that we shall be able to go on financing our universities by charging fees to students from the RUK, despite the fact that EU law forbids discrimination against other member states.  Right.  So we think that they will let us get away with charging the English provided we don't charge the Bulgarians?  Seriously?

That's to be going on with.  When I hear the answers to these I'll start on the rest of the questions.

Ask a Silly Question

It is annoying that the standard of the independence debate remains low.  Such an important issue deserves better.

For example, we are told that most people agree with the proposition "decisions about Scotland should be taken in Scotland". What a surprise. Surreptitiously sliding emotional bias into surveys is a standard method of distorting results.

Suppose we consider a few other questions formatted in a similar way. For example, do we agree that "decisions about banks should be taken in banks"? Is it purely a matter for bankers to determine whether our deposits should be invested wisely or repaid on demand? No? Thought not.

Perhaps the Northern Isles might care to claim that decisions about the Northern Isles should be taken in the Northern Isles? How would Edinburgh respond to the assertion that "It's Shetland's oil"?

Let us pursue the logic further. Can anyone think of any reason why decisions about me should be entrusted to anyone but myself? What's all this nonsense about having to obey laws?

It should be fairly obvious that it is almost impossible to take decisions affecting one part of a community that do not affect other parts of that community, sometimes very seriously. For any society to be viable, its members must sacrifice some of their individual freedom to the greater good. The real question is therefore whether the value of the greater good is more than the value of the sacrifice.

Now let's think. What would be a good example? How exactly did Scottish banking get bailed out during the financial crisis? Who is placing the warship orders that could keep the Clyde shipyards open? Who decided to give Scotland a bigger share of UK public spending per head than England?

Or perhaps these are the sort of decisions about Scotland that should be taken in Scotland?

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? 

An Open Letter to Sir William Wallace

Dear William,

I may call you William, mayn't I? I have known you a long time after all. Please stop turning in your graves. This is a very unhealthy habit for someone who is over seven hundred years old and already divided into four quarters. Let me reassure you that no historically knowledgeable Scot ever took seriously your so-called biography by that Australian. (Australian, William, is a modern word meaning a descendant of criminal outcasts.)

We know that you did not wear a kilt, paint your face, shoot arrows, attack stockades or meet the Queen of England. (In fact William, it was Sitting Bull, a more modern person than you, who did all of these except wear a kilt.) We also know that you were not called Braveheart; that was a turncoat French contemporary of yours.

Your name was not really Wallace either. It was le Walys. You were descended from a travelling companion of the French knight Walter Fitzallan, later known as Stewart, who arrived in Scotland in 1136. Your home at Elderslie was a quite presentable manor house and not a peat-roofed shack. You were well educated and spoke Latin as well as French, though you probably did not quote from Tacitus before battle as the Australian did.

You see, William, the problem is that the truth is rarely politically correct. History needs to be viewed through a strongly coloured glass that makes it allegorically relevant to today's political agenda. Given that you encountered a fair bit of revisionism in your own struggles, I am sure that you understand that history, first written by the winners, is then re-written by the government of the day.

William, you may have noticed that our future is now to be decided by competitive telling of fairy tales. We are going to mark the seven hundredth anniversary of Bannockburn by organising a popular vote. You probably know about Bannockburn, don't you? It was when your successor as Guardian, Robert 'Braveheart' de Brus, the French usurper of the Scottish throne and the earldom of Carrick, defeated another bunch of French-speaking invaders in 1314 near Stirling.

You may find it ridiculous, William, but nowadays it is generally believed in Scotland that Bannockburn was fought between the Scots and the English rather than between rival gangs of Frenchmen. They call your era 'The Scottish Wars of Independence' when what was really going on was a struggle to decide which Frenchman should rule what. Honestly, most folk nowadays don't seem to know that invading Frenchmen took over England in 1066 and Scotland in 1072 and then spent the next four centuries trying hold on to both. French was still the language of the London court and administration for almost a century after Bannockburn..

William, they want us to believe that your enemy was called English Edward, not Édouard de Plantagenet. They want us to believe that his army was led by barons who spoke English nigh on two hundred years before the English language evolved into anything recognisable today. They want us to believe that you and de Brus were both Scottish patriots despite neither of you being from Scottish families. Most ridiculous of all, they want us to believe that these things have even the slightest relevance to how we should govern ourselves today.

William, we are celebrating the septcentennial of this quarrel between Frenchmen by having a plebiscite to decide whether Scotland and England should get a chance to fight each other again properly, this time without French interference.

Apparently Scotland has not chosen a Conservative government for ages but has repeatedly had one imposed on them by the English. This, according to the Scots, is a bad thing. (Conservative, William, is a modern word which means the same as feudal baron.)

As it happens, England does not choose Labour governments either but has repeatedly had one imposed on them by the Scots. This is a bad thing according to the English. (Labour, William, is another modern word for feudal baron. I know, it sometimes confuses me too.) Two of the last three prime ministers (the modern word for kings) of our United Kingdom have been Scots and the third one is called Cameron, which suggests he has a mite more Scottish ancestry than you did, William.

I still don't think it's a good idea for you to be turning in your graves, but if you did feel able able to jot down a few lines (in French will do fine,) setting straight some of this modern pseudo-historical hogwash, the person you should write to is nowadays called First Minister, not Guardian, of Scotland, and he stays in Edinburgh.

Yours,

Philip

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.