Gavin McCrone: Matter of no small change

Too much emphasis is placed on the Scottish share of UK debt
Too much emphasis is placed on the Scottish share of UK debt
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The SNP’s declared preference for sticking with sterling, even for a transitional period, would be far from a simple matter for an independent Scotland, writes Gavin McCrone

Alex Salmond has said that, in the event of Scotland becoming independent, his policy would be to retain sterling as its currency until such time as it was appropriate to join the euro, when that would be decided by referendum. Since then, John Swinney has suggested that joining the euro would only be a distant prospect. To many people this may seem just a technical issue but in reality it is of the greatest importance for those of us living in Scotland.

European Monetary Union has failed. That much is clear. I say this with sadness because I have been, and still am, a strong supporter of the European Union. But any system that can force on a country the kind of calamity now unfolding in Greece, with austerity on a scale otherwise only experienced in time of war, is totally unacceptable. Greece’s problems are, admittedly, partly its own fault. It should not have joined the euro, and had its true financial position been known it would not have been allowed to. But that is not true of Portugal, Spain, Italy and Ireland, all of which are now also facing austerity on a far greater scale than Britain.

Had it worked, monetary union could have given the member states great benefits: ending transaction costs between the countries and removing exchange risk for businessmen trading across country borders. But monetary unions only work if inflation is at broadly comparable rates between the member states. This condition has not been met. Whereas unit labour costs in Germany have only risen slightly since 1999, in Greece they are 30 per cent higher, and in the other countries at least 20 per cent higher, than they were then. The resulting loss of competitiveness is shown in the deficits on the current account of their balance of payments, in all of the countries except Ireland which, on the latest figures, has managed a small surplus. This compares with a substantial surplus for Germany.

Countries with their own currencies can restore competitiveness by devaluation, but within the eurozone this is impossible. If gains in productivity can be found from structural reforms, this can help, but that takes time. Otherwise, prolonged deflation and austerity are the only remedy. So, added to the problem of excessive debt following the banking crisis, which is demanding austerity, many eurozone countries are also having austerity forced on them in the hope of restoring lost competitiveness.

It remains to be seen whether this can be done without a social breakdown. Ireland, which has the most flexible economy, seems relatively well placed to do so, as is shown by its small balance of payments surplus. But even here the austerity required for the bail-out has seen unemployment rise to 13.6 per cent (24 per cent for 15-24 year olds) despite renewed emigration.

Spain has unemployment of 5.2 million – 23 per cent of the labour force and 49 per cent for those under 24. Greece is the extreme case, with a sharp contraction of 7 per cent in its economy over the last three months of 2011 and many businesses facing bankruptcy. The latest bail-out package requires a further 150,000 jobs to go in the public sector and the minimum wage to be cut by 22 per cent. Despite a proposed 53.5 per cent write-down by private bondholders, which include many banks in other countries, pension funds and individual savers, Greece’s burden of debt is likely to remain unsustainable.

Faced with this, it would not be surprising if various extremist candidates won support in the forthcoming elections. In my view, the latest bail-out only buys a bit more time. I expect a full default is now inevitable and I think that the support from the EU would be better spent in managing such a default and in helping Greece to leave the euro.

What does this mean for Scotland, if it becomes independent after the forthcoming referendum? Certainly Scotland would be wise not to join the euro, at least if there is any doubt at all about its ability to maintain the competitive position of its economy against other eurozone countries. On past UK experience, that seems unlikely.

But staying with sterling is not straightforward either. It would certainly involve negotiation with the rest of the UK. Scotland could not expect the Bank of England to remain as lender of last resort for the Scottish banks and economy, as this would be a potential cost for taxpayers throughout the rest of the UK. This might mean that the markets would rate Scottish Government bonds as higher risk than those of the rest of the UK, which could affect the cost of borrowing.

Scotland would have no freedom to alter interest rates as these would be set for sterling by the Bank of England. Even on fiscal policy Scotland’s room for manoeuvre would be limited. One of the conclusions being drawn by eurozone countries at present is that monetary union requires a high degree of fiscal coordination, if not outright fiscal union with harmonisation of some tax rates. The proposed treaty for eurozone countries seeks to bring this about, and it remains to be seen whether all of the eurozone countries will find it acceptable. An independent Scotland within a sterling monetary union would face exactly the same issues.

It is interesting therefore to look at how Ireland handled these matters when it became independent in 1922. Immediately on independence sterling continued to be used throughout Ireland; there was no money market in Ireland and Irish bonds were sold in London. This meant that there was no lender of last resort. Mercifully one was not needed, but the activity of speculators was at nothing like the level it is now, which would probably have made this impossible.

The then Irish Free State government ran an extremely conservative fiscal policy, not attempting any kind of fiscal stimulus to ward off the depression of the 1930s. It was not until 1928 that Ireland introduced its own currency – the Irish pound (in Irish the punt); this was managed by a currency commission but there was no Irish central bank until the Central Bank Act of 1942. Throughout this time, and indeed right up until 1979 when, unlike the UK, Ireland decided to join the European Exchange Rate Mechanism (ERM), monetary union with sterling continued. My own experience of visiting Ireland during the 1950s and 1960s was that Bank of England notes, and even coins, were freely exchangeable with those of the Central Bank of Ireland, just as today Scottish banknotes are exchangeable with Bank of England notes.

During the 1980s and 1990s, the punt was within the fixed rate system of the ERM. It fluctuated widely against sterling, and within the ERM there were several realignments with the punt depreciating against the deutschmark. There were fears that the link with the deutschmark within the ERM might have required an unacceptable discipline, but this did not arise because the option of depreciation was available.

The lesson I draw from this is that an independent Scotland could not continue to use sterling as if nothing had changed. A lender of last resort would be required to deal with speculative pressures and possible crises. This would require a Scottish Central Bank and it should issue its own currency, which could be pegged to sterling. If a Scottish Government did not always want to accept policies decided for the rest of the UK and objected to oversight of its fiscal policy by authorities in London, its exchange rate could be altered. The possibility that this might happen, however, could affect the price and rate of interest of Scottish Government bonds.

All of this just goes to show that the declared option of staying with sterling would be far from a simple matter for an independent Scotland, and how that is dealt with would have major implications for the economy. There is a good deal to be considered and explained before we vote in the referendum.

Gavin McCrone was formerly chief economist at the Scottish Office