A well-managed Scottish economy could develop an tradable currency which would ﬂuctuate in value around the pound, writes John Kay
The choice of currency would be the most important economic decision for an independent Scotland. All aspects of economic policy, including ﬁscal and monetary arrangements, are contingent on that choice, which would have to be made in consultation with the UK and the European Union and would require their agreement, or at least acquiescence. Destabilising speculation would begin as soon as a referendum vote went in favour with businesses and ﬁnancial market participants positioning themselves to beneﬁt from, or at least avoid loss from, the changes. A decision by the Scottish Government could not therefore be long delayed, although the ﬁnal outcome would depend on negotiation.
Such a decision would not be irrevocable, but the opportunity for an independent Scotland to reconsider its currency options poses problems as well as offering opportunities. An independent Scotland would have three principal currency options: it could adopt the euro; it could retain the pound, either by agreement or through unilateral action; or it could adopt its own currency.
The euro is formally the currency of the European Union and members are required to prepare for its adoption. Unless, implausibly, Scotland simply inherited the opt-outs from the Maastricht Treaty obtained by the UK, Scotland would be expected to move towards eurozone membership. If Scotland did join the eurozone, monetary policy – and particularly the level of interest rates in Scotland – would be determined by the European Central Bank (ECB).
There would be a premium, or conceivably a discount, relative to UK interest rates reﬂecting the perceived creditworthiness of the Scottish Government. Scottish ﬁnancial institutions might be perceived as better, or worse, credit risks than a Scottish Government. Scotland would be entitled to a representative on the governing council of the ECB. Scotland would also participate pro rata in the various arrangements, including the stability mechanism, which have been devised in support of the euro.
At an earlier stage of discussion of Scottish independence, there were suggestions that euro membership would represent a powerful declaration of Scotland’s economic independence from the UK and an assertion of its place in Europe. But a more hard-headed approach is now appropriate, and generally accepted. It is evident now – and it should have been evident at a much earlier date – that, from a purely economic perspective, Irish membership of the eurozone was not a sensible decision.
Irish membership of the euro was in large part a political statement and while some in Scotland might want to make a similar assertion, the attractions of eurozone membership have fallen signiﬁcantly as the zone itself has come under pressure.
The sensible currency union for an independent Scotland is with the rest of the UK (rUK), and Scottish adoption of the euro is not appropriate so long as rUK does not use the euro. A pragmatic acceptance that Scotland might aspire to eurozone membership – at some time in a future so long delayed that no-one could foresee a date – would be a sensible arrangement for both Scotland and the EU.
But the immediate question is whether the implicit premise of the debate taking place within the eurozone is correct: could there be a monetary union between Scotland and the rUK in the absence of any intention, or expectation, that the arrangement would lead, even in the long run, to comprehensive economic integration, including common ﬁscal policies and internal transfers? This view has become conventional wisdom in markets as well as in European political circles, but is probably exaggerated. Nevertheless, it would inevitably influence the negotiating positions of the EU and rUK.
But even if the arrangements between Scotland and rUK fell short of ﬁscal union, there would certainly be a requirement for some ﬁscal co-ordination between the two countries, since substantially looser or tighter ﬁscal policies in one country would inevitably have an impact on the other. In the light of the recent eurozone experience, it is hard to imagine rUK countenancing either deﬁcit or debt levels in Scotland signiﬁcantly in excess of those for the UK as a whole within a currency union.
The credibility of the European Stability and Growth Pact was quickly undermined when it was ignored by France and Germany. This deﬁance by large countries of agreements reached collectively points to a serious difﬁculty in economic co-operation, and speciﬁcally in ﬁscal coordination, between Scotland and rUK: the asymmetry in the size of the partners. It is easy to see why rUK, representing 91.5 per cent of a monetary union, might seek oversight of the economic affairs of Scotland, representing 8.5 per cent of the same union. It is more difﬁcult to see why rUK, representing 91.5 per cent of a monetary union, should concede oversight over its policies to Scotland, representing 8.5 per cent of the union. But, in the absence of such reciprocity, the degree of autonomy Scotland would enjoy in ﬁscal policy might differ very little from the modest amount Scotland currently enjoys under the allocation of a block grant within the UK.
Scotland might reasonably ask for membership of the Bank of England’s monetary policy committee. Such a demand might be conceded, although there has been ﬁrm resistance to the idea of representative, as distinct from individual, members of that committee.
The choice of members of the committee is intended to exclude direct political inﬂuence on decisions, and Scotland would be expected to follow this principle: thus it would be acceptable to choose an economist with Scottish connections, but not one whose brief was to represent the particular interests of Scotland (to the extent that an appropriate monetary policy for Scotland appeared to differ from that appropriate for rUK).
Monetary policy for Scotland would, therefore, be determined by a mechanism over which Scots and Scottish interests would have at best marginal inﬂuence and, by design, no political inﬂuence.
It is not necessary to agree the terms of a monetary union to establish a common currency. Countries can unilaterally choose to use the money of another country. The option of using another country’s money is often called dollarisation, because the dollar is the currency most commonly used in this way.
Most of these states are very small countries such as Monaco (euros) and the Turks and Caicos Islands (dollars). The largest country to have followed this dollarisation route is Ecuador. There is no modern analogue for the adoption of such a policy by a country of the size and economic sophistication of Scotland. The likely reason is that dollarisation is not a very attractive route.
If Scotland chooses not to link its currency to the euro, and cannot secure an appropriate basis for linking its currency to the pound, then the only option that remains is an independent Scottish currency. If acceptable terms of monetary union cannot be agreed, then Scotland would introduce its own currency, which might initially be pegged to the pound.
Given the modest size of its foreign exchange reserves, Scotland would encounter difﬁculty in establishing conﬁdence in its ability to sustain that peg.
Scottish interest rates would necessarily follow those set by the Bank of England for rUK, but Scotland would have freedom in ﬁscal policy subject to the requirements of prudence imposed by capital markets, and it is likely that a well-managed Scottish economy could develop an internationally tradable currency which would ﬂuctuate in value around the pound.
If such an outcome does not seem ideal – and it does not – it reﬂects the acknowledgement of a central reality. The degree of economic independence available to a small country, like Denmark or Sweden, close to its major trading partner and associated with a large currency block and customs union is, in a global market for goods, services and capital, inevitably limited. But these examples suggest that such an outcome is entirely feasible.
• John Kay is visiting Professor of Economics at the London School of Economics, and Fellow of St John’s College, Oxford and a former member of the Scottish Government’s Council of Economic Advisers. This is an edited extract from Scotland’s Future: the economics of constitutional change, a new economic commentary on constitutional options facing Scotland, edited by Professor Andrew Goudie, of the University of Strathclyde. It will be published on 26 March, priced £16.99. Available from www.dundee.ac.uk/dup