The Currency Question

The debate over independence is plagued with speculation about how the economic system will adapt and whether a constitutionally independent Scotland will deliver better economic outcomes for Scots than the Union. Within this wider debate, the issue of what money will look like is becoming more prominent, and has generated significant heat, if not much light, in recent days. The SNP’s policy for some time was that Scotland would join the Euro ‘when the time was right’ and only after asking the permission of the Scottish people. The right time seems to be receding into the future, however, and staying in a sterling area monetary union is now the preferred option. This is no longer an obscure or technical discussion; in particular, strains in the Eurozone since 2010 have highlighted the difficulties of operating a single currency across a range of sovereign states.

So, Scots will have some choices to make in the wake of a Yes vote in 2014: stick in a monetary union with the UK and keep the pound, move into the Eurozone or launch a new national currency. That these are the three options is the one thing that is largely uncontentious, and they were reiterated by George Osborne when he presented the Treasury paper in Glasgow in April. In fact, however, these choices are not as distinct as they might appear. In a globalised economy, a country like Scotland that profits from international trade, seeks to attract international investment and wants free movement of workers across borders already has significant limits to its economic policy sovereignty. Constitutional independence will not deliver economic independence, if by independence is meant an absolute right to do as you please without consultation and agreement with neighbours and partners. So some measure of interdependence is inevitable. This is true for all states engaged with the global economy, including the UK. But there remain shades of difference among the three currency choices.

Adopting the Euro could facilitate trade and payments with Europe and lend credibility and confidence to investors who trust the European Central Bank’s monetary policies. While Greece, Cyprus and other Eurozone states have faltered through not ensuring fiscal balance and diverging from the healthier economies in the Eurozone, there is no need for Scotland to fall into this trap. Scotland’s economic performance for some time has been such that it could sit comfortably in the ‘core’ Euro group of countries, and its debt levels (below those of the rest of the UK) would give comfort to other members. On the other hand, with Eurozone GDP contracting and the future of the Euro uncertain, 2015 does not seem a good time to join.

What about introducing a separate Scottish currency? Recent examples of currency disintegration are not very numerous: after constitutional independence in the 1950s and 1960s, a range of former British colonies introduced separate currencies as emblems of their new status but in practice they pegged the exchange rate to the pound, so the amount of monetary independence they achieved was limited. In the same way, new currencies followed the collapse of the Soviet Union and the creation of new states in eastern Europe during the 1990s, the division of Yugoslavia into Slovenia and Croatia in 1991, and the separation of the Czech and Slovak republics in 1992 (Slovakia and Slovenia subsequently adopted the Euro). In each case there were disruptive effects on trade and payments that were expensive and hurt economic performance for both partners. The lessons from earlier episodes, such as Malaysia and Singapore in the 1960s suggest that a gradual approach of disengagement with a common currency and then free transfer and convertibility of separate currencies across borders at par and then management of a stable exchange rate is likely to be most effective. The separation of Malaysia and Singapore in 1963 was fraught with political hostility, but the successful transition to independent currencies was co-operatively managed over 10 years during one of the most volatile decades in the global economy. Two things emerge from this analysis. First, it can be done. Second, it takes some time and a mature attitude to negotiation in the interest of both states.

Given that both the Euro and a separate currency will constrain policy-making, perhaps the simplest and least costly option is to stay in a currency union with the pound. The Scottish Government’s fiscal commission was very clear that this was the sensible and pragmatic choice: it reduces uncertainty in the short-run and provides security to cross-border investors and producers who might otherwise be concerned about the impact of independence. But the lessons of the Euro-area need to be heeded – which is why George Osborne consistently used the phrase ‘Euro-style’ to describe the option of a continuing currency union. It would require that Scotland abide by the interest rate policy set by the Bank of England, which historically has responded more to economic conditions in the Southeast of England than the regional needs of the UK as a whole. The implied fiscal constraint is real, though not necessarily disastrous. Scotland and the rest of the UK have very similar economies and meet most of the tests applied to define Optimum Currency Areas. A continuing currency union would also offer substantial benefits to the rest of the UK by continuing to link sterling to the considerable balance-of-payments benefits afforded by North Sea oil. Within a currency union, the Scottish government would have policy flexibility, and would be able to make independent spending choices – within the agreed overall fiscal envelope.

This is where the economic argument lies, and there are two sets of risks that need to be considered. First, John Kay argued in a recent lecture at the University of Glasgow that the stresses induced by divergent policy choices around education, social welfare etc. could, in the long-run, result in pressure for Scotland to adopt a different exchange rate or interest rate policy. Secondly, Jim Cuthbert’s recent contribution to the debate has pointed out that economic instability in the rest of the UK could be seen as a major risk to the Scottish economy if it remains tied through the currency union. The IMF’s criticism of Osborne’s austerity policy and downgrading of British debt suggest that the international community is also starting to doubt London’s economic priorities. In the longer term, the freedom to make appropriate currency adjustments could be in Scotland’s best interests. The status quo already meets the needs of a distinctive national representation on currency notes that could evolve into the first stage of a gradual move toward disengagement (we can dismiss the reported difficulty in continuing to issue Scottish sterling notes in the short-run – it is not clear why the Bank of England would refuse to accept the assets which currently support them), but this is likely to be a long process begun well after constitutional independence once the current global recession and uncertainty are behind us.

Three things are clear from this discussion: first, there is little space for independent monetary policy for a small open economy such as Scotland, no matter what currency option is chosen by the post-independence government. This is an inevitable consequence of the need to engage in the global economy and is true to some extent of every country. Second, a continued currency union between Scotland and the rest of the UK is the sensible and pragmatic option in the short term, giving as it does a level of security to investors in both countries. Third, the right to pursue independent policy choices is one of the key goals of independence and it is conceivable that these choices might eventually lead to significant pressure to decouple from the rest of the UK and float an independent currency. Alternatively, without continued access to North Sea oil wealth, it is possible that the r-UK deficit will lead Scottish policy-makers to the view that continued stability requires a decoupling from sterling. In the short-run, therefore, sterling is sensible and good for both countries. In the long run, an independent Scottish currency may well be the best way forward.

Catherine Schenk and Duncan Ross
University of Glasgow

Catherine Schenk is Professor of International Economic History, University of Glasgow, and author of The Decline of Sterling (Cambridge 2010).
Duncan Ross is Senior Lecturer in Economic History at the University of Glasgow.