In September 2014, Scottish voters will decide whether to leave the UK and become an independent state. It will be a straightforward Yes-No referendum, but each person’s vote will be based on a mixture of rational and emotional considerations. The currency question touches both, and therefore it could be the deciding factor in this historic decision.
Last week’s publication by the UK Treasury, Scotland Analysis: Currency and Monetary Policy, deals with the rational side. It reviews the theory of optimal currency areas and concludes that Scotland and the rest of the UK, under the current arrangements, fulfil the criteria for a mutually beneficial currency union relatively well. The two areas’ economies are closely enough integrated that a single monetary policy is appropriate; fiscal transfers have cushioned regional downturns; and the Bank of England’s role as “lender of last resort” to Scotland’s two large banks saved their depositors and bond holders from severe losses during the global financial crisis. However, these current arrangements would end if Scotland voted for independence. There would be no further cross-subsidies through fiscal policy, and the Bank of England would not be obliged to stabilise Scotland’s financial institutions in case of turbulence or mismanagement.
If Scotland wished to retain sterling as its currency, as its nationalist first minister leader Alex Salmond currently maintains, it would either have to set up a currency board and thereby give up any control over its interest rates and face much higher government borrowing costs; or it could seek to negotiate a new arrangement with the UK government and BoE. This much is clear from the Treasury analysis. However, Scotland’s economy is less than one-tenth the size of the UK’s. Its bargaining power as the smaller actor would be correspondingly limited. Both the Conservative and Labour parties oppose Scottish independence so the UK Parliament of the day is unlikely to offer any favours. In particular, to gain lender of last resort coverage, Scotland would have to meet stricter budgetary and debt constraints than it does today, negating the assumed benefits of independence.
The Treasury paper examines two other currency options for an independent Scotland. It could seek to join the euro, although it would first have to meet the bloc’s deficit and debt criteria. This option might be forced on an independent Scotland as a condition of remaining in – or rejoining – the EU as the new nation would no longer benefit from the euro opt-out Britain negotiated for itself. The fate of peripheral euro area members since the financial crisis does not make an appealing case for this option.
The remaining option of a new Scottish currency – call it the scottie – is the default case, which does not depend on uncertain negotiations and probably has the most emotional appeal to those inclined to vote for independence. It is the only option that would allow Scotland to set its own monetary policy and make its own trade-offs with fiscal policy. There would be clear costs, compared with the current arrangements. Transaction costs would increase for Scotland’s trade, including that with the rest of the UK. The scottie’s exchange rate could fluctuate wildly if the new country’s government lacked or lost credibility in international markets. But there are successful examples of other small European countries with their own currencies: Norway, Sweden, Denmark and Switzerland, in particular. Each has unique characteristics and some have adopted a “shadow link” to the euro, perhaps a model for linkage of the scottie to sterling.
Launching a currency and its supporting institutional arrangements would be complex and require careful planning. With the vote less than two years away, those who are campaigning for independence had better start on the prenatal preparations for the scottie.
This commentary appeared in The A-list blog on FT.com on 1st May 2013