If Scotland were to have another independence referendum, the country would need to have a credible currency plan in place since, in the eventuality of a Yes vote, such a plan would be critical in determining how smooth the transition to independence actually is.
The variants of sterlingisation, widely touted in the 2014 referendum and more recently in the Growth Commission’s report, are non-starters.
An independent Scotland would therefore need its own currency, with an associated central bank. Crucially it would need to choose either to have some form of fixed exchange rate or to let the currency float.
Since it is widely accepted that an independent Scotland would have a significant fiscal deficit on becoming independent, a fixed rate can be ruled out, since both the starting level of reserves would be insufficient to provide a credible regime and the country would also need to run very conservative fiscal policies. Surpluses would be necessary to accumulate the needed foreign exchange reserves to sustain the regime, which would also hugely limit the independence of the central bank since the bank would need to subordinate monetary policy to the defence of the regime.
This leaves a floating exchange rate as the only credible currency regime. This has the advantage of maximum flexibility in the operation of its monetary policy, but it also has two significant downsides.
Floating exchange rates are known to be volatile, especially for a newly minted country, which would introduce friction into Scotland’s trade with the rest of the UK (RUK). Second, currency flexibility would create capricious valuation effects to the many billions of pounds of cross-Border assets and liabilities that exist between Scotland and RUK.
l Ronald MacDonald is research professor of macroeconomics and international finance at Glasgow University’s Adam Smith Business School