Keeping pound after independence may well be a sterling idea

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CAN a country be politically independent yet still use the currency of another nation? And, if so, what limitation does this place on the economic policy of the new state?

These questions have arisen because of the announcement by the SNP government, in its St Andrew's Day paper on future constitutional arrangements, that following independence "Scotland would continue to operate within the sterling system until a decision to join the euro by the people of Scotland in a referendum".

There is precedent for such an arrangement. Despite the bloody conflict that led to Irish independence from the UK in 1922, Dublin pragmatically retained a fixed-parity currency arrangement with sterling till 1979, when Ireland joined the European Monetary System.

The initial rationale was simple: Irish trade relations were linked umbilically to the UK and any exchange rate uncertainty would have been disastrous. The Irish confined themselves to printing some beautiful domestic notes called punts, though Bank of England notes were interchangeable and circulated widely in the Republic.

This did not mean the Irish were in economic thrall to London: not a phrase one would have used to Eamon de Valera's face. Ireland set its own taxes and tariffs, aimed at building a domestic manufacturing base. Nor is it true to say Ireland lacked a degree of local monetary control. After 1938, Dublin set about creating a central bank that exercised an increasing degree of influence over domestic credit expansion. This was achieved by subjecting Irish banks to reserve and lending controls – something that would be open to an independent Scottish administration.

The Irish experience is germane as the SNP's proposal to keep sterling pro tem after independence has provoked criticism as to its workability. Indeed, the Scottish Liberal Democrats have written to ask Bank of England Governor Mervyn King how he would respond to such a set-up. Would independent Scotland, for instance, have a say in UK interest rates?

King's reply is suitably Delphic, as befits a central banker: "It would not be possible for (UK] interest rate decisions to take account of inflation in an independent (Scotland] with its own fiscal policy, in the absence of a proper monetary union framework."

Does this mean an "independent" Scotland that kept sterling would be dependent on the Bank of England's monetary policy committee? But that's not what the Governor said – he raised the prospect of a genuine monetary union to which both parties contributed. The last thing the Bank of England would want is an oil-rich Scotland able to influence the exchange rate of sterling acting without consultation with the Bank itself.

Going back to the Irish example, the Bank of England happily co- operated with Dublin to promote mutual monetary stability. The Irish issued their own punts but backed every one with gold, UK government securities or sterling deposits. In return, the Bank of England guaranteed that Irish banknotes could be exchanged at par in sterling (without fee, margin or commission) in the UK.

If an independent Scotland kept the pound sterling, it is unimaginable that there would not be some form of joint consultation over interest rates – just as in the eurozone the separate national central banks have a say in setting the overall European interest rate.

How long would the Scottish link with sterling last, assuming London stayed out of the eurozone? Currently, Scotland's biggest trading partner is the rest of the UK, with trade worth 36.1 billion in 2007. In that year, our exports to the rest of the world were only 20.7bn. The sterling link makes sense for Scotland until that trade balance changes or the peg suddenly produces unacceptably perverse results; for example, massive imported inflation from England.

The SNP has always made the case for independence on economic grounds. Does maintaining the peg with sterling necessarily invalidate this argument? Independence would still mean the right to set taxes to fit local needs – such as a much lower corporation tax to attract foreign investment.

Indeed, if an autonomous Scottish fiscal policy boosted growth without incurring a structural deficit similar to the one generated by then chancellor Gordon Brown, the risk premium on Scottish Government debt would fall. As a result, we could still see high street interest rates lower in Scotland than in England, even with the sterling peg.