CURRENCY WARS – A Newsnet Scotland analysis of the currency options for an independent Scotland



WHAT are the currency options for an independent Scotland? Basically there are four:
(1) joining the euro; (2) keeping the pound, as the SNP now proposes; (3) creating a Scottish pound – or whatever else you want to call it – but fixing it in value one-to-one with English sterling, as Ireland did after it gained independence; or (4) having a Scottish pound that floats on the international exchange markets like the currencies of Sweden, Norway and Denmark.

No one is keen on an independent Scotland joining the euro in its present uncertain form. For a start, the eurozone won’t let you join before a long preparatory period. Second, the euro is in chaos, which would undermine business confidence in an independent Scotland using the euro. Third, the Scottish electorate are opposed.

With the euro out of contention, the SNP is proposing that Scotland remain part of a common sterling currency area after independence. The advantages are that it minimises the economic disruption and cost to the economy of creating the new state.

Sharing currencies promotes trade and eliminates exchange costs. What’s not to like? New Zealand was part of a common sterling area for a long period after 1945.

Note that a common sterling area is not the same thing as the status quo. The Bank of England (hopefully with a new name) would not be the central bank of the Rest of the UK (RoUK) but of all the nations using sterling.

These could also include the Republic of Ireland. There is a view gaining ground in that country that if Scotland becomes independent and keeps the pound, Ireland should quit the euro and join the new sterling area.

An independent Scotland would appoint a representative(s) to the “new” Bank of England’s monetary policy committee (MPC) that sets interest rates.

Recently, David Blanchflower, a former member of the MPC, has said it is “probably not unreasonable” for an independent Scotland to have this representation. It would even be a good idea under devolution. Currently, the US Federal Open Market Committee, which sets American interest rates, has mandatory representation from its regional affiliates.

Unionists will argue that in any such common currency arrangement the Bank of England, not the Scottish Government, would still set a common interest rate for Scotland and RoUK.

The Bank would remain the body that prints pounds (albeit electronically). By offering to lend these pounds to the financial system, the Bank sets a floor on interest rates throughout the sterling economy. Scottish banks could not undercut the Bank of England interest rate, because it would still be the Bank that provides their financial safety net.

However, as John Swinney, the Scottish financial secretary, has pointed out, that still leaves a lot of scope – far more than under devolution – for independent Scotland to use its tax powers to promote investment, attract foreign capital, advantage particular industrial sectors, or cut VAT to boost consumption.

Swinney’s point was that an independent fiscal policy would trump the austerity currently forced on us by Westminster. Who cares if interest rates are still set by the Bank of England – we have that anyway.

However, while this is true, there is a risk. The UK has been prone to high inflation as a result of an overheating economy in the South East. This imposed a higher interest rate than was good for Scotland, ending in de-industrialisation. Unless the new, common Bank of England is given a mandate to promote economic growth across the whole British Isles, rather than merely police inflation for the City, the Scottish economy might suffer.

Why would RoUK want to join a common sterling area with Scotland? An independent Scotland with its own separate currency could cause lots of problems for the RoUK economy.

If Scottish interest rates were even a smidgeon above London’s, capital would flood northwards. Remove Scotland’s oil and whisky foreign currency earnings and the RoUK’s trade deficit would be chronic. Businesses in England hoping to sell to Scotland would also benefit from keeping a common currency. Being part of a common sterling bloc means Scotland would agree to share its foreign currency reserves with RoUK.

In this system, the new Bank of England would also regulate Scottish banks. It would act as “lender of last resort” to banks north or south of the border, meaning it would provide cheap credit to ensure the banks remained solvent.

There has been some Unionist criticism that this would not be possible as the EU demands each member state regulate its own banks. But all the EU requires is that each member state have a proper regulatory system in place. It would be perfectly possible for this to be the Bank of England, especially as the Bank is undertaking this task already.

What would happen if a bank failed in Scotland? The Scottish Government would be liable for protecting depositors here, even if it was a subsidiary of an English bank. If a bank failed in England, the RoUK Treasury would be responsible for insuring their deposits, even if it was a subsidiary of a Scottish-owned bank.

This is because under European law every bank must be registered to operate in a given country (i.e. take local deposits). That country’s authorities are then responsible for insuring their own depositors, even if it is technically a foreign bank.

Thus if Santander fails, the UK Treasury would cover British depositors in Santander’s UK subsidiary. (Incidentally, had RBS failed under an independent Scotland, the English Treasury would have been legally bound to aid English depositors, not the Scottish taxpayer.)

That said, after Scottish independence, in the event of a bank failing which had major operations on both sides of the Scottish-RoUK border, one would expect a joint rescue operation by both governments, in the interests of maintaining confidence in the financial system. (People forget there was a similar multinational rescue of Foris by the Benelux countries.)

One objection raised to having a common sterling area is that Scotland would have to accept common fiscal controls as well. In other words, the Scottish Government would have to accept voluntary limits on its borrowing. A similar fiscal compact is being introduced in the eurozone after the Greek crisis. Unionists ask why Scotland should bother with independence if it means having not just interest rates but also public spending determined from outside?

But this is a distortion of what would actually apply. The fiscal rules in the eurozone, and in any future sterling area, are to stop governments borrowing more than they can pay back (as with Greece). This is a perfectly sensible rule, which one hopes Scotland would keep to anyway, even if it were not in a sterling bloc with England. And for the record, remember it was Gordon Brown who plunged the UK into unsustainable public debt, so voting against independence hardly guarantees national solvency.

Even under the fiscal stability rules of a common sterling area, the Scottish Government would set its own budget priorities. The amount it could borrow safely would actually be governed by Scotland’s rate of economic growth – the more growth, the greater the tax revenues, the more you can afford to borrow.

What if RoUK refused to accept a common sterling currency with an independent Scotland, despite the benefits on both sides? The fundamental problem for the SNP is that there is no guarantee the RoUKers will see sense, even if they are cutting off their sterling nose to spite their economic face.

In that case, the next option would be to have a separate Scottish pound, issued by the Scottish monetary authorities, but which had exactly the same value as the English pound.

Thus a pound Scots and a pound English would have exactly the same value and be interchangeable. This was the policy adopted by Ireland when it first became independent. This arrangement would make trade simple.

How do you keep the Scottish pound and the English pound exactly the same value as each other?

Step one: a new Scottish Central Bank issues Scottish pounds which would be the sole legal tender in Scotland. However, banks and businesses requiring Scottish pounds would buy them from the Scottish central bank in return for sterling.

Thus the total of Scottish pounds in circulation is backed by a reserve of sterling to an equivalent amount. If there is 1 billion pounds Scots in circulation, it is backed by 1 billion pounds English at the Scottish Central Bank. So anyone with a pound Scots knows they can go to the Scottish Central Bank and swap it for a pound English.

A Scottish pound fixed against sterling has many of the advantages of a full sterling currency union, plus a degree of flexibility. In particular, the Scottish Central Bank, not the Bank of England, would be lender of last resort to the Scottish Government and banks. As Scotland’s sterling reserves accumulate, they can be lent in the sterling money markets to earn interest.

However, it would still mean that Scotland needed to keep the same interest rates as RoUK. Higher interest rates would suck in capital from England, expanding the Scottish money supply and causing inflation. A rise in RoUK interest rates would normally force the Scottish authorities to raise rates in parallel, to stop capital flowing to London, which could hurt growth.

The smaller European economies that weathered the 2008 credit crunch and recession were those with independent currencies. They had the ability to devalue, boost their money supply and control their own interest rates.

Sweden reacted instantly to the downturn with a remarkable injection of quantitative easing from its central bank – unlike eurozone members who can’t print their own euros. As a result, Swedish GDP is back where it was in 2008, before the downturn.
The problem with setting up an independent currency is the disruption, transition costs and impact on business confidence in the short run. There is also a problem in establishing credibility in the bond markets. This makes going for a separate currency a hard choice.

A more likely scenario, in the event of RoUK rejecting a sterling union, is that Scotland creates a Scottish pound fixed to the English pound. But then after a matter of years – probably if RoUK interest rates become too high – abandons the fixed exchange rate and lets the Scottish pound float.

The No camp will hide behind calls for “more details” on the currency issue. In fact, the basic position is quite clear: a common sterling area is simple, helps business and is good for both Scotland and RoUK.

But those who oppose Scottish independence might well reject a sterling solution out of political spite, even though this goes against the long-term interests of the people of England, Wales and Northern Ireland.