Is Scotland’s currency as sound as a pound?

Professor of Economics at Strathclyde Business School, Robert E. Wright, looks at the debate around whether or not Scotland would be able to keep the pound as an independent country.

The Chancellor of the Exchequer, George Osborne, has categorically ruled out the SNP’s promise of currency union between Scotland and what is left of the UK after independence. Alex Salmond has hit back saying the move is nothing more than a backfiring tactic ahead of the referendum.

But let’s look at the issue – a currency union is a grouping of two or more countries which use the same currency and pursue a common monetary policy, such as setting the same interest rates and following the same banking regulation. It is in effect a way of sharing the responsibility for monetary policy between two countries who believe both will benefit from doing so. Clearly the UK Government does not believe this will be the case with an independent Scotland. Now that Plan A is derailed, what is Plan B?

The SNP don’t have one and they will now need to think again. There are however several possible alternatives. One is for an independent Scotland to use the pound anyway. A country can use any currency it likes. For example, Montenegro uses the euro, Ecuador uses the US dollar, Liechtenstein uses the Swiss franc, etc. In fact, Zimbabwe officially uses five foreign currencies, while its own currency is suspended! Some economists refer to such an arrangement as an “informal currency union, which has some features common with the negotiated more “formal” currency union wanted by the SNP Government.

In practise using the pound without the blessing of the UK Government means that the Scottish Government would have no influence over monetary policy. It is of course debatable how much real influence Scotland would have in a formal currency union given the big differences in the relative sizes of the economies. In addition, as Mark Carney, Governor of the Bank of Bank of England, recently reminded us, for a currency union to work effectively, fiscal policy pursued by the partners must not diverge widely. Effectively this means that monetary and fiscal policy in an independent Scotland would be heavily determined by what policies followed by what remains of the UK. This means that the big increases in government expenditure promised by the SNP Government seem very unlikely. Personally, I find it a rather odd form of independence to argue for an arrangement where your two main forms of economic policy are effectively carried out by the country you politically want to split from.

Another alternative is for Scotland to create its own currency, let’s call it the “saltire”. This would allow Scotland to pursue monetary and fiscal policy of its choosing. However, the problem is that it is likely that the international currency markets would not act favourably towards the saltire when it is introduced. Why? It is expected that an independent Scotland will inherit a significant share of the national debt. That is, an independent Scotland would be a new, small and heavily indebted country. Not a great start to say the least. This would almost certainly lead to a serious under-valuation. In addition, it would make trading with what remains of the UK more expensive since this would involve foreign exchange transactions and would do nothing to reduce the cost of trading with all other countries.

The further alternative is to use the euro. Scotland could enter into an informal currency union with the euro. Once the Maastricht criteria are met (especially the debt requirement), it could join the euro area, which is a formal currency union consisting of 18 members states of EU. This would lower the cost of trade with those countries who use the euro but make the cost of trade higher with what remains of the UK. A trade-off that now needs to be seriously considered. It seems clear that Scotland will need to apply for EU membership. It is unlikely that the seamless transition promised by the SNP Government will occur. As a consequence, an independent Scotland will need to commit to the using the euro in the future anyway (as have all new member states who have joined since 2004). Perhaps it is time for the SNP Government to look to the future and not dwell on the past when it comes to the currency we will use in an independent Scotland.

What do you think about the great currency debate?