Currency Wars – The Empire Strikes Back

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  By George Kerevan
 
THE independence white paper has landed on the political runway – all 670 pages of it.  In rebuttal, the boss of Project Fear, Mr A. Darling, was quick to take to the BBC airwaves parroting what has become the central line of the No campaign: the white paper has not answered the fundamental question of what happens if rUK rejects a common sterling currency zone. 
 
What, demanded the Chancellor in charge when the City of London imploded, is the SNP’s currency Plan B?

I sincerely doubt if Mr Darling had actually read the white paper at that point.  His response had already been scripted, as had that of the Westminster Government.  Alex Salmond had hardly finished his introduction when the BBC was reporting “senior sources” in the Coalition that the currency question was the SNP’s Achilles’ heel.

It is becoming very clear that the No campaign high command has zeroed in on the currency issue as its leading area of attack.  In the days running up to the publication of the white paper there were a series of orchestrated interventions by leading No politicians on this subject.

Carwyn Jones, the Labour First Minister in Wales, travelled to Edinburgh to put his oar in, calling the SNP proposal for a common currency “a recipe for instability” and not in the interests of Wales.

Alistair Carmichael, the new Lib Dem Scottish Secretary of State, popped up on the Andrew Marr Show the Sunday before the white paper, saying a common currency “…wouldn’t work.  It wouldn’t work for Scotland and it wouldn’t work for the rest of the United Kingdom”.

Meanwhile, the London press has been full of Treasury-inspired leaks hinting strongly that Chancellor Osborne would veto a common sterling link.  It is in the nature of these leaks that Osborne never has the courage to go on the record – he is canny enough to know that would smack heavily of political blackmail (which it is).  Nevertheless, a message is being sent loud and clear that Westminster is going to play hardball over the currency in the hope of deflecting a Yes vote.

The SNP position, as reiterated in the white paper, is that retaining the sterling link is in the interests of both Scotland and the rUK – whatever Alistair Carmichael or Carwyn Jones argue.  And because it is in the joint interest, the SNP believes that Westminster will have to negotiate a common currency regime after a Yes vote, regardless of the current hostile signals from the Treasury.

Below, we answer questions about a common sterling block arising from the white paper.  Messers Carmichael and Jones please read and digest:

WHY KEEP STERLING?

The simple answer, at least in the medium term, is that it is the simplest option during the constitutional transition.  All Scotland’s prices, pensions, investment projects, debts and savings are calculated and valued in sterling.  Changing that would cause uncertainty, disrupt business, create a situation where prices conversions could be fiddled, and add to business costs.  Who needs that?

There is a second gain to do with government borrowing.  The government of an independent Scotland will have to do its own borrowing on the international markets.  It will start without a credit track record.  Keeping sterling makes Scotland’s accounts and budget plans more transparent.  Also, the markets are familiar with sterling accounts and view sterling as a low risk currency.    

WHAT DOES SCOTLAND GIVE UP IF WE KEEP THE POUND?

Keeping sterling means we will continue to have the same interest rates as the rUK.  Reason: If we tried to set lower interest rates, money would flow out of Scottish banks and head south and if we had lower rates rUK would cut theirs to stop the reverse happening.

The problem here is that the rate of interest we end up with – which will still be set by the Bank of England – may not suit independent Scotland. Traditionally, interest rates have been higher in the UK than the rest of Europe in order to fight inflation generated by the City of London and the over-heated economy of the English South East.  That hurt Scottish business and wallets.  Staying with sterling after independence could leave us with the same problem.

There is a second issue: keeping the pound means we have a common exchange rate.  So if the pound goes up in value against foreign currencies like the euro and dollar, Scottish exports will be hurt.  A Scottish central bank would not be able, say, to devalue to boost Scottish sales abroad.

However, Scotland inside the UK currently has to live with interest rates and the exchange rate set by the Bank of England.  In that sense, keeping sterling after independence makes us no worse off.  When Darling, Carmichael and Jones pretend to worry about independent Scotland being disadvantaged by the currency link they happily ignore just such “disadvantages” hold true at the moment.

Where a currency union trumps the current set-up is that it should properly include separate Scottish representation on the Bank of England’s Monetary Policy Committee, which sets interest rates.  Scottish representation should help ensure the rate set takes into account Scottish needs.

One reason that Carwyn Jones seems worried by a common currency zone is that he thinks that Scots representatives on the Monetary Policy Committee might demand an interest rate that disadvantaged Wales.  Clearly Mr Jones is not aware the Bank of England already (and habitually) sets rates that are not in the interests of Wales.  Surely it would be better to use the advent of Scottish independence to reform the Monetary Policy Committee to have representation from all the UK nations and regions.

WHAT DOES SCOTLAND GET IF WE KEEP THE POUND?

An independent Scotland, even keeping sterling, will have the ability to create a new taxation system tailored to local needs, one that helps the economy to grow.  Critics argue that such fiscal autonomy could be granted under devolution.  That is a false claim.

First, not one iota of devolved powers has ever been granted to Scotland by Westminster except under the threat of independence.  Second, the Treasury is particularly resistant to giving up powers over corporation tax – witness its stubborn refusal to grant Northern Ireland such powers.  Third and most important, the current UK system of taxation is a bureaucratic mess that is unfit for purpose.  Devolving fiscal autonomy to Scotland inside the UK would let a Scottish government vary tax rates but it would not give Holyrood the scope to completely rewrite the tax code – that only comes with independence.

This, indeed, is the main argument of a paper published by the respected Institute of Fiscal Studies (IFS) just before the publication of the white paper.  The IFS report was seized on by the No campaign as proving an independent Scotland would have to raise taxes if it wanted to maintain current levels of public spending as the population ages.  Actually, such a fiscal gap hold true for Scotland inside or outside the UK, and for the UK itself.  With income tax anyway being devolved to Holyrood in 2016, whoever runs Scotland is going to have to cope with that.

However – and here is what the No campaign deliberately ignored and the media missed – the same IFS report pointed out that an independent Scotland (and ONLY and independent Scotland) was in a position to refashion the tax structure to promote economic growth and so raise the necessary cash to fill any so-called fiscal “black holes”.

According to the IFS:

“…the current system of income taxes and welfare benefits creates serious disincentives to work for many with relatively low potential earning power. The benefit system in particular is far too complex (though the proposed universal credit will help to some extent)…Scottish independence would provide an opportunity to make sensible changes to the tax system in Scotland that successive UK governments have failed to make…the creation of a new state is surely the best opportunity that is ever likely to present itself for radical and rational tax reform, starting from first principles, which has the potential to unlock really significant economic benefits”.

WHAT IF rUK BLOCKS A CURRENCY UNION?

Alistair Darling followed the publication of the white paper by again demanding what would be the SNP’s Plan B if Westminster cuts its own throat and rejects a common sterling area.

The answer is…er, Plan A.  Scotland will go on using sterling the day after independence because that’s what we use already.

What difficulties would arise in these circumstances?  Actually few at all as regards the operation of the currency itself.  Prices, savings, benefits and pensions would still be priced in pounds.  Banks would still lend in pounds – most monetary transfers are electronic and by definition don’t use paper notes printed by the Bank of England.

One modest problem might be access to new pound notes in sufficient quantities for cash transactions in Scotland (paper notes being notoriously short-lived).  But as most banks operating in Scotland will still operate in the rUK, they will have the ability to acquire new notes directly from the Bank of England to service their Scottish branches.

Theoretically, the rUK Government (in some weird fit of pique) could try to block access by Scottish bank branches to Bank of England notes, though why it would bother is unclear.  The answer would be for the Scottish Government to mint its own coins (including pound coins) redeemable on demand for large denomination Bank of England notes from the Scottish monetary authority.

That said, there are three real problems that arise from keeping sterling without negotiating arrangements for a formal currency zone:

(1) Scotland would have no direct say in the determination of the base interest rate by the Bank of England.

Clearly, that could lead to circumstances where the rate was not in Scotland’s economic interest.  However, in the immediate future (say the next 5 years) this is of modest importance as rates are likely to stay at historic lows due to the economic crisis.  In the longer term, a Scotland growing faster than the UK, and with a government in better control of its finances, will have a strong international credit rating.  For all practical purposes, that will negate the problem of being tied to rUK base rates.

(2) We could end up importing rUK inflation.  Scotland could not counter by raising our own interest rates.

Again, this is not going to be a problem for a while as British inflation is low (though higher than elsewhere in the industrial world because output is so low).  If it did become a matter for concern, you can reduce inflationary demand by raising taxes.  A runaway property boom imported from rUK could be halted by making buyers put up bigger deposits.

(3) The Bank of England would not guarantee to buy Scottish Government bonds, as it does for UK debt at the moment.  That would make Scottish public borrowing relatively dearer, all things being equal, as there would be a higher theoretical risk.

We might begin by pointing out that as the Scottish Government under devolution has only the most limited right to borrow (under the new Scotland Act) and even then with a Treasury veto hanging over it.  Arguing Scotland’s capital could be more expensive that for the rUK is hardly a deal breaker for independence when you can’t actually borrow very much at the moment anyway, to boost the economy.

Yet there is an issue here.  A new nation faces a degree of scepticism from lenders.  Add in the fact there is no central bank to buy its bonds on the open market (to put a floor on the price) and there is bound to be a risk premium on Scottish state borrowing over rUK rates.  But having admitted that, Messers Darling, Carmichael and Jones can’t declare game, set and match.

The risk premium that a Scottish administration will pay for borrowing is directly linked to how responsible it is.  This risk premium is usually measured by how much a government has to pay to borrow over what Germany has to pay (Germany being the soundest risk).

Measured on 25 November, the UK Government pays +1.05 per cent over the German rate.  But a host of well-managed, smaller European states pay far less: Austria (+0.35), Denmark (+0.08), Finland (+0.19), Netherlands (+0.32), Sweden (+0.56).  Even Ireland, with all its recent problems, has a risk premium of only +1.80, which is hardly extortionate.  And Switzerland, whose banks in 2008 were in every bit as trouble as Britain’s, now actually pays less for public borrowing than Germany!

Conclusion: An independent Scotland that has sensibly reformed the chaotic UK tax system, is borrowing in a sustainable fashion, and which is growing faster than the rUK, will in reasonable time face a risk premium for state borrowing on a par with the other small European industrial nations.

The alternative, of course, is to stay in the UK and have no significant freedom to borrow or make the capital investment in infrastructure needed to raise Scottish productivity.

WHAT DOES rUK GET OUT OF A CURRENCY UNION?

One new element in the currency debate is Carwyn Jones’ allegation that Wakes and rUK would suffer in a currency union.  Given that England, Scotland, Wales and Northern Ireland are in a currency union as we speak – which, doubtless, he supports – then Mr Jones’ analysis is a trifle confused to say the least.

Nor is it clear, beyond finding a stick with which to beat local nationalists, why the Welsh First Minister wants to add to the business costs of Welsh firms by making them pay for currency conversions when trading with an independent Scotland.  Given that unemployment in Wales is far higher than in Scotland, Mr Jones would be better employed fixing the Welsh economy than lecturing Scotland.

In fact, rUK would gain from a currency union – which is why the SNP Government white paper thinks agreement will be reached despite the ill-informed arguments of Messers Darling, Carmichael and Jones.  As well as reducing business transaction costs and keeping cross-border trade simple, retaining a common sterling area minimises the rUK’s growing trade deficit.  Taking Scotland out of sterling would add circa £50 billion to rUK’s trade gap.  It would not be long before the markets punished any rUK government for running such a large and unsustainable trade imbalance.

CONCLUSION

The white paper, while it won’t silence the No camp, shows the Scottish Government has thought through the mechanics of building a new nation state in more detail than, I think, any national movement before.  And in quiet distinction to the fear and uncertainty spread by Messers Darling, Carmichael and Jones, it is a tribute to the SNP Government that its white paper tries to look at what is best for rUK as well as for Scotland.  Of such leadership and wisdom nations are forged.