Bank of England governor’s sortie north of the Border has put the cat among the pigeons on the issue of a post-independence currency
WHEN Mark Carney left Scotland after his first visit north of the Border as governor of the Bank of England last week, both sides of the independence debate were quick to claim victory.
For Yes campaigners, his assurance that the Bank would implement Alex Salmond’s plans to keep the pound (subject to negotiations with the UK government) was a major step forward. On the other side of the argument, his analysis of currency arrangements was hailed as acknowledgement of the risks Scotland would face and confirmation that Salmond’s independence model falls short of true financial autonomy.
In the aftermath of Carney’s historic visit, Scotland on Sunday lays out the pros and cons of the various currency arrangements that could be adopted after a Yes vote.
STERLING – FORMAL CURRENCY UNION
A FORMAL currency union with the rest of the United Kingdom is the economic model favoured by Alex Salmond and the Scottish Government’s White Paper.
This arrangement would allow an independent Scotland to keep the pound, and its proponents believe it would provide stability, while giving the Scottish Government the power to alter fiscal policy, handing over economic levers that would enable Scottish ministers to tax, spend and borrow.
A fundamental aspect of such a currency union is that the Bank of England would retain control over monetary policy – interest and exchange rates – both sides of the Border. Another key aspect would be a banking union governed by a consistent regulatory framework and a cross-Border mechanism to sort out banks that get into difficulty.
It was Carney’s treatment of this currency (or monetary) union and his statement that there would have to be some “ceding” of national sovereignty for it to work that led to impassioned debate on whether the White Paper would deliver true independence.
Although Salmond has argued Scotland ought to be represented on the Bank’s Monetary Policy Committee, there is little doubt a formal currency union leaves an independent Scotland with minimal control over interest rates.
In theory, an independent Scotland would have power over fiscal policies – tax, spending and borrowing. But just how much autonomy is now subject to fierce debate.
A successful monetary union requires tight fiscal arrangements among participating governments and limits on tax and spend in order to enforce prudent behaviour and prevent countries from relying on others to bail them out.
The need for fiscal co-operation has been acknowledged by the Scottish Government’s Fiscal Working Group led by Nobel laureate economists Joseph Stiglitz and Sir James Mirlees. But the big question is whether the “fiscal sustainability agreement” proposed by Salmond’s Nobel prize-winners will satisfy the rest of the UK.
According to Dr Angus Armstrong of the National Institute of Economic and Social Research, the key point Carney made was that for a monetary union to be successful Scotland and the rest of the UK would have to “share” fiscal risk, if an independent Scotland is to be protected against future financial crises.
“Sometimes when a [financial] shock is so big, you try to borrow money to correct this. And if you have to borrow so much that people doubt whether you can repay it, they are going to charge you a higher interest rate for doing it,” Armstrong explained.
“Then you get into this self-fulfilling negative spiral, which Carney talked about – runs on banks etc. The only way out is that the richer countries say we will temporarily loan you money to tide you over the bad times and when things are back to normal you give the money back. That is fiscal risk-sharing and you need to create a mechanism to do that.”
Although Carney declined to elaborate on how fiscal risk-sharing would work, Armstrong believes it could have an impact on Scotland’s North Sea oil industry and that windfalls would have to be shared to compensate for any shared losses. Aside from the philosophical question of how much real independence Scotland could achieve under this, there is also the question of practicality.
The rest of the UK dwarfs Scotland by a factor of ten when it comes to economic activity. This has led some experts to complain this would not be a relationship of equals. The rest of the UK would be able to bail out a troubled Scottish economy. But Scotland would be unable to reciprocate.
Nevertheless, for most members of the Yes campaign and the Scottish Government keeping the pound within a formal sterling-zone represents their best option.
However, influential figures within Yes Scotland – most notably its chairman Dennis Canavan and the Green leader Patrick Harvie – believe Scotland would be better served by its own currency.
Alistair Darling’s Better Together campaign sees little merit in leaving monetary policy to a “foreign country” and points out Scotland already uses the pound and benefits from a UK banking system.
With the UK government indicating it intends to play hard-ball during the negotiations after any Yes vote, there remain questions over whether the Treasury would be prepared to let Scotland enter a sterling-zone. Hence the clamour for Salmond and his finance secretary, John Swinney, to publish their “Plan B”.
Creating a new Scottish currency – whether the groat, the bawbee or the Scottish pound – may have its attractions.
STERLING - INFORMAL CURRENCY UNION
THIS differs from Salmond’s model in that Scotland would continue to use the pound, but without the consent of the rest of the UK.
That would deny an independent Scotland access to the Bank of England.
A comparable model is the informal currency union that Panama has with the US dollar. This model, however, is seen by economists as problematic because, without a link to a central bank, an independent Scotland would have no safety net when financial crises strike. In the event of financial difficulty, investors would choose to hold money in core currency south of the Border, which would have central bank protection rather than the domestic Scottish one. Should a crisis engulf Scotland, the Bank of England would have no obligation to step in to help.
SCOTLAND’S OWN CURRENCY - FIXED
ONE option would be to peg the new Scottish currency to the pound in a similar way that the old Irish punt was fixed to sterling. It is a model that has worked reasonably well for Denmark – a country of similar size to Scotland. The Danish krone is pegged to the euro at around 7.45, an arrangement which has offered remarkable stability over the past decade or so.
Technically-speaking, a Scottish central bank would have control over interest rates. In reality, the Scottish central bank would have to follow the interest rates set by the Bank of England. Otherwise, speculators would attempt to borrow money from the country with the lower interest rates and pump the cash over the Border where there was a higher rate – an unsustainable scenario. Unlike the formal monetary union, there would be some transaction costs – the cost of changing money from one currency to another – which may discourage some businesses.
Although the new Scottish currency would be tied to the pound in a one-to-one ratio, in the event of a financial crisis there would be some flexibility. The Scottish Government could take a decision to adjust its currency if there was a strong enough case to do so.
Creating a Scottish currency is favoured by many independence supporters, who are hopeful that a formal currency union may provide a vehicle to reach their preferred destination.
This may provide the most autonomy and may be the option that is most consistent with the notion of independence, but there are many challenges to be overcome.
Persuading the public to give up a strong currency like pound is the most obvious political difficulty. From an economic perspective, there is the substantial task of persuading the markets that a newly independent country with no track record and substantial debt will use its greater autonomy prudently.
SCOTLAND’S OWN CURRENCY - FLOATING
THIS economic model would also see the creation of a brand new Scottish currency, not pegged or linked to any other currency. The value of a floating Scottish currency would be allowed to fluctuate according to the foreign exchange market.
Perhaps the most obvious example of this is the British pound. But it is a system that is operated by other strong economies, notably the US dollar and Swiss franc.
When it comes to nations of a comparable size to Scotland, the most obvious example is the Norwegian krone, which over the past ten years has fluctuated between a high of 9.95 against the euro to a low of 8.00 – a high degree of movement.
As in the establishment of a fixed Scottish currency, setting up a floating one would incur one-off transition costs to form a central bank and replace sterling in circulation.
The subsequent uncertainty over the future value of the floating currency could lead to high transaction costs, a feature which would do much to discourage business.
Unlike the fixed currency model, the Scottish Government could alter interest rates. But operating a different interest rate from the rest of the UK would have implications for the value of Scotland’s currency.
The floating arrangement means that a large-scale movement of cash from Scotland to England would be offset by the value of the Scottish currency falling – a phenomenon observed by John Maynard Keynes and known as his “Uncovered interest rate parity theorem”. Keynes’s theorem states that the difference in interest rates between two countries is equal to the expected change in exchange rates between the two countries.
Such an arrangement would allow a Scottish state to choose its exchange rate, fiscal and monetary policies.
The downside for independence supporters is that a more volatile exchange rate could affect domestic wages and prices. Volatility would interfere with fiscal policy.
Campaigners for a No vote say the risk posed by volatility and the high transaction costs mean that the benefits of staying within the UK and keeping the pound outweigh the risks of going it alone.
There is another option that would allow an independent Scotland to keep the pound and that is entering an informal currency union with sterling.
EURO - INFORMAL CURRENCY UNION
THIS model would see an independent Scotland adopt the euro in the same way that Montenegro has. Montenegro has adopted the euro without being a member of the Eurozone. Like an informal currency union with sterling, this arrangement would mean that Scotland would not have a link to the central bank.
Under this model, an independent Scotland would suffer from all the disadvantages that are inherent in an informal union.
The European Central Bank would be under no obligation to alter interest rates to benefit Scotland in difficult economic circumstances. Similarly the European Central Bank would not be beholden to offer emergency packages should an independent Scotland run into financial trouble.
The more likely and more secure scenario would be for Scotland to enter a formal currency union with the euro.
EURO - FORMAL CURRENCY UNION
On the face of it, as a model the euro has many similarities with monetary union with the rest of UK, except that interest rates would be set by the European Central Bank rather than the Bank of England.
There would, however, be transaction costs associated with changing the euro into pounds when doing business over the Border. But it is the troubles that have beset the Eurozone in recent years that make this a far less appealing option.
There is the danger that policy set by the European Central Bank would be less suited to the Scottish economy than that set by the Bank of England. Joining the euro, however, would see Scotland constrained by the European Union’s fiscal framework and the banking union that is currently being developed in order to try to bring more stability across the Eurozone.