Scotland’s currency future: what economists think

A panel of leading economists considers Scotland’s choices

The Financial Times asked a panel of leading economists to consider four currency options available to an independent Scotland: currency union with the UK; the continued use of the pound sterling but without the backing of the Bank of England; forming a new currency; and joining the euro. The following ratings – marked out of 10 – are based on what our panel members believe are the best options for Scotland, rather than what is most likely to happen.

Dame DeAnne Julius, former Monetary Policy Committee member and Bank of England court director

Currency union with the UK: 10

A currency union with the rest of the UK is the optimal currency policy for Scotland. Both the Yes and No camps agree on this. The existing currency union has stood the test of centuries and protected Scotland through world wars and global financial crises. Both of Scotland’s big banks have been bailed out by British taxpayers and Scotland’s budget deficit is financed by sterling debt, backed by the Bank of England’s reputation for never defaulting.

The only problem for Scotland is that if it votes Yes, the existing currency arrangement is no longer on offer. Taxpayers from the rest of the UK (RUK) have no reason to continue supporting the banks and budget deficit of an independent Scotland. All three political parties have made this clear. So the only way for Scotland to have a currency union is to vote No to independence.

Sterlingisation: 7

At least in the immediate period after independence, the next best option to a currency union is for Scotland to continue using sterling but without the support of the Bank of England or any RUK guarantee of its sterling-denominated debt. This would facilitate continued trade between Scotland and the rest of the UK, and it would provide the least disruption to Scottish companies’ exports and financing needs. However, without currency union an independent Scotland would lose the protection of the BoE so if Scotland repudiates its share of British debt – as Mr Salmond has threatened – it will find itself in a budgetary straitjacket, forced to raise taxes or cut spending, because financial markets will shun its new debt issues.

And there will be no safety net for Scotland’s banks. There may be few Scottish banks in any case, as the larger ones would probably move south of the border to protect shareholders and reassure customers.

A separate currency: 5

An independent currency – let’s call it the “Scottie” – could work for an independent Scotland and it is the only available option that would allow the country to set its own monetary policy and make its own trade-offs with fiscal policy. But transaction costs would increase for Scotland’s businesses and the initial period of uncertainty when the Scottie is introduced would be likely to cause capital flight and a wildly fluctuating exchange rate. As a small country with no record of currency management, Scotland would be more likely to be classed with Greece (but without support from the European Central Bank) than with oil-rich Norway. Unlike the latter, Scotland’s oil production peaked 15 years ago.

Join the euro: 1

This is a non-option for Scotland, at least in the short term. It would first have to apply to join the EU as an independent country, and then it would need to qualify for eurozone membership based on its fiscal deficit and inflation rate. In any case, the Scottish economy is more closely aligned with the rest of the UK than with the eurozone, so policy set by the ECB in Frankfurt would be worse for Scotland than a sterlingisation policy set in London. Even Alex Salmond has changed his mind about joining the euro.

Sam Bowman, research director at the Adam Smith Institute

Currency union with the UK: 5

In many ways a currency union would be business as usual for Scotland and the least problematic short-term option. However, EU regulations may still require RBS and Lloyds to domicile in the City even under a currency union. In addition, Scottish sovereign debt may trade at artificially low rates thanks to the implicit backing of the BoE, encouraging unsustainable borrowing.

Most seriously, without fiscal transfers between Scotland and the rest of the UK, there is a danger that Scotland would not be able to do anything in response to demand-side shocks to the economy, potentially resulting in prolonged and harmful periods of deflation for Scotland.

Sterlingisation: 9

Sterlingisation could be Scotland’s best option in the medium to long term, especially if combined with banking reforms allowing banks to issue their own promissory notes, backed by the pound sterling on a fractional basis. With no central bank to act as a lender of last resort, banks would be required to make private provision for such facilities. International evidence from the dollarised Latin American states, notably Panama, Ecuador and El Salvador, suggests that this would improve bank soundness by eliminating moral hazard.

Without restrictions on note issuance (and the monopoly protections that encourage excessive issuance), banks would expand and contract their balance sheets in a countercyclical fashion, offsetting changes in velocity with immediate changes in the money supply, reducing the risk of the sort of demand-side recession that took place globally in 2008. This radical option may prove difficult to transition to in the short term, however.

A separate currency: 7

The option of an independent Scottish currency has been unfairly maligned. A free-floating currency would indeed be at risk of speculative attack but with the right mandate it could have substantial benefits as well. For example, were the Scottish central bank to target nominal gross domestic product instead of following an inflation target, a Scottish currency would provide a stable macroeconomic environment that adjusted to shocks automatically, keeping nominal spending levels (or aggregate demand) constant (in a similar way to the free banking option, albeit through a different mechanism). By keeping spending constant along a predictable growth level, an independent Scottish currency would lose purchasing power in recessions but would avoid the “musical chairs” problem of sharp drops in nominal GDP leading to unnecessary structural unemployment.

A free-floating currency would be at risk of the Dutch disease, however, with Scotland’s substantial resource wealth making its other export sectors relatively uncompetitive.

Joining the euro: 2

Joining the euro carries the same risks as a currency union with the UK but on a greater scale. The eurozone is already far from being an optimal currency area, and it is easy to imagine shocks to the Scottish economy (such as a drop in oil prices) that would be barely felt in the rest of the eurozone and hence would receive no policy response.

On top of these potential dangers the ECB has already proven itself to be a badly run institution in practice, strangling the eurozone, stifling recovery and pushing up unemployment with tight money. There is almost nothing positive to be said for this option.

Professor Anton Muscatelli, University of Glasgow

Currency union with the UK: 10

This would be the best option, not only for an independent Scotland but also for the rest of the UK. Scotland and the UK are very highly integrated economies, with mobile labour and capital. The benefits to Scotland of a sterling monetary union are very clear, with two-thirds of its exports going to the UK. The benefits to the UK are also clear. Roughly 40 per cent of UK exports to the EU are to and from Scotland, as are 23 per cent of its imports. For both countries abandoning a monetary union would introduce transaction costs, which for UK businesses might be around £500m-£2.5bn.

The usual arguments against a monetary union – asymmetric shocks and the dependence of Scotland’s finances on oil revenues – are exaggerated. These concerns wrongly extrapolate from the eurozone experience. A Scottish-UK monetary union would need to be supported by a fiscal rule for both countries with proper enforcement mechanisms, and a fiscal smoothing of oil revenues by the Scottish government through an oil stabilisation fund.

Sterlingisation: 6

This is a transition option but not a good long-term one. Scotland could continue to use sterling outside a formal monetary union. One benefit of this arrangement is that it would avoid transaction costs. A major disadvantage, however, is that the BoE would not act as lender of last resort to the banking system in Scotland.

It would also not be a desirable option for the UK. Scotland is much bigger in proportion to the UK than Panama is to the US or Montenegro to the eurozone – the other countries that use this arrangement. Having 10 per cent of its money supply used across its border would be a source of potential macroeconomic instability in the UK. Sterlingisation should be seen as a short-term option as Scotland transitions from the pound to its own currency and it develops its payments system, its central bank and lender of last resort, and its prudential regulation system.

A separate currency: 8

An independent Scotland could issue its own currency, supported by its own central bank. Many successful European countries of a similar scale have chosen this option, for example, Sweden and Denmark. Scotland would then have to choose how to manage its exchange rate. Given the importance of trade with the UK, shadowing the pound as Denmark does with the euro might be a good option, but this could be reassessed over time as Scotland’s industrial and economic strategy develops.

The chosen macroeconomic strategy would also depend on what agreement is reached on debt sharing. If Scotland inherits a lower level of debt because of a failure to agree a monetary union, this will influence the chosen exchange rate strategy for the new currency. The introduction of a new currency will require an orderly transition to contracts denominated in the new currency. This is best done in a planned way, guaranteeing existing contracts in sterling.

Joining the euro: 2

The eurozone has been mired in economic difficulties. It has suffered from poor macroeconomic governance and its economies have less trade integration and less labour and capital mobility than Scotland and the UK. The project was poorly executed because it brought monetary union to a group of countries that was less integrated and which did not satisfy even the most basic criteria for an optimum currency area.

Indeed, the euro is an example of how bad politics can wrongly trump good economics. With the benefit of hindsight, countries like Greece should not have joined. As the UK, Scotland’s biggest trading partner, will never join the eurozone, then if bad politics removes the best option (a Scottish-UK monetary union) then it is best for Scotland to have its own currency and manage its exchange rate against the pound (through a shadowing or fixed-rate arrangement).

Tony Yates, Reader in Economics at University of Bristol

Currency union with the UK: 10

The status quo, with a currency union and full fiscal (and therefore banking) union is definitely best for Scotland. But full fiscal and banking union would negate all but the symbolic purpose of forming a new state. Yet anything less would not be on offer from the RUK. The SNP view this as a bluff, but to me the logic seems clear: the RUK does not want to recreate a model of the disastrous euro on its own turf. With an unusually large financial sector, and oil reserves, it is an odd optimal currency partner for the RUK. But it has lasted, and in 50 years the oil will have gone.

Sterlingisation: 5

Sterlingisation may be the default option in transition but not good in the longer term. Monetary policy in the RUK would not be that different if Scotland departed (Scotland is only one-tenth the size of the UK economy). But a new Scotland would have to run large budget surpluses for a long time to build up what would be a foreign currency reserve adequate to provide a makeshift lender of last resort for its banking sector.

And there would be no fiscal flows into Scotland to compensate when its cycle is out of sync with the rest of the UK. It could gamble on the UK forking out (just as it did to Ireland recently) but that might or might not materialise, and may not come quickly enough, or at an appealing price. And worries about just that may make a crisis more likely to happen – and, if it does, worse.

A separate currency: 7

Despite the transitional costs, floating its own currency and pursuing inflation targeting would be the best bet for Scotland that is politically feasible (that is, assuming that the Scots do not want a currency union on terms the UK will offer – namely, tight fiscal controls). There are several other small open economies doing the same, and successfully: Sweden, Norway, New Zealand, for example. The flexibility and lender of last resort protection afforded by a new Central Bank of Scotland would allow the independent country to retain more of its financial sector (than with sterlingisation or joining the euro) and exploit that expertise.

Join the euro: 3

The eurozone looks like it is heading for deflation. The possibility of a disorderly break-up was stayed, but not completely eliminated, by ECB president Mario Draghi’s “do whatever it takes” declaration. Tiny steps are being made to instigate a banking union but it will probably never amount to enough to act as a proper lender of last resort for the Scottish financial sector. The ECB mandate is inflexible and overly conservative, and the ECB governing council unwieldy. The only thing holding the ECB to account is the German constitutional court. This is not the time to join the euro. Of course, if Scotland manages to negotiate separate entry to the EU, it may be forced to.

Angus Armstrong, director of macroeconomics at the National Institute of Economic and Social Research

Currency union with the UK: 3

Under any reasonable voting rules at the BoE, Scotland would have little, if any, influence on monetary and financial policy. With a public debt burden of more than 80 per cent of GDP and highly volatile tax revenues, Scotland would have no room for manoeuvre in overall fiscal policy. Borrowing costs are likely to be substantially higher. Any large adverse shock could lead to doubts about debt sustainability and bond investors refusing to refinance Scottish debt and a government funding crisis.

A formal currency union without political union invites moral hazard. Since Scotland could not influence UK monetary policy, there would be no reason to impose fiscal constraints on Scotland. There would also be no incentive for the UK to negotiate a banking union as Scotland would withdraw in the event of a large UK banking crisis. So any attempt to even broker a formal currency union, while being serious about moral hazard, would end up like sterlingisation.

Sterlingisation: 1

Sterlingisation appears to offer continuity but in fact much would change. This is the riskiest of all currency arrangements being considered. With a debt burden of more than 80 per cent and projected fiscal deficits, Scotland would have little capacity for independent macroeconomic policy. It would have no capacity to provide emergency liquidity to its financial sector and little scope for a credible deposit insurance scheme (for instance, Panama does not offer deposit insurance).

Financial services are Scotland’s largest export sector. Scotland’s non-oil trade deficit has been around 7 per cent of GDP over the past three years. Therefore, the loss of financial services exports would leave the balance of payments very exposed to declining oil and gas revenues. The fall in general prices and wages to restore competitiveness could be substantial. As we have seen, governments with high debt levels, no control over their currency and external deficits can also need emergency support.

A separate currency: 6

The Scottish government says the goal of independence is to build a country that reflects Scotland’s “priorities as a society and values as a people”. If Scotland had its own currency, this would provide greatest economic sovereignty, which the Fiscal Commission acknowledges. It would make sense to peg the new Scottish currency to the UK pound to minimise transaction costs and allow for periodic adjustments as the economy evolves. A Scottish central bank could provide emergency liquidity to financial institutions and shape its own financial policy.

Scotland would be fully responsible for its own future and the fate of its currency would depend on its policy priorities and choices. Whether residents and investors consider these policies to be credible will determine if the currency rises or falls. Talk of choosing to repudiate a fair share of the UK’s debt makes credibility harder to achieve. The transition would be difficult and uncertain with the redenomination of contracts and the introduction of many new institutions.

Join the euro: 3

Whether joining the euro in the near term is even feasible is doubtful. An independent Scotland would not meet most of the Maastricht criteria. It cannot fulfil the exchange rate stability criterion until it has its own currency first. If Scotland were to secede from the UK and choose to repudiate its fair share of UK debt, then even joining the EU might be difficult as member countries might be eager to avoid setting such an extraordinary precedent for other regions in Europe with secessionist movements.

If it were possible, Scotland would join a union in which it has a voice in setting monetary policy. But using the euro would imply substantial exchange rate volatility with the UK, its largest trading partner by far. Scotland would also be required to introduce a fiscal pact, which might be challenging to fulfil given its exposure to oil revenues. Scotland would join the nascent European banking union, which may provide some euro liquidity support to its financial system, an advantage over sterlingisation.

Ronald MacDonald, professor, Adam Smith chair of political economy, University of Glasgow

Currency union with the UK: 1

If an independent Scotland gains a geographic share of North Sea oil it will become a net exporter of hydrocarbons and its non-oil sector will suffer the classic “Dutch disease”, loss of competitiveness relative to its main trading partner, the rest of the UK. Absent large wage and price cuts, or very high levels of unemployment, this is not a sustainable system and will create a currency crisis at great cost to Scotland and the UK.

Based on IMF data on the costs of a currency crisis, this could be anywhere up to £100bn for Scotland alone. As the eurozone experience has shown, such a regime is also inconsistent with the Scottish government’s repeated claim that monetary union will give it 100 per cent control over fiscal policy.

Sterlingisation: 0

Again, this option does not provide an independent Scotland a means of addressing competitiveness changes and therefore will not be seen as credible by financial markets. Furthermore, the informal use of sterling would mean that Scotland’s highly developed and sophisticated financial sector would have no lender of last resort facility, which would be disastrous, resulting in this sector effectively moving south of the border with considerable implications for exports and employment.

In contrast to the GDP of Panama relative to that of the US, Scotland’s GDP is a significant proportion of UK GDP, with potentially important implications for monetary control in the rest of the UK. Sterlingisation would also require the accumulation of vast amounts of foreign exchange reserves to be sustainable.

A new currency: 9

This is the only option that offers an independent Scotland an adjustment mechanism to address unfavourable movements in its competitiveness and provide maximum freedom of monetary and fiscal policy. This should have been plan-A and plan-B since it is the only plan financial markets will regard as credible.

It is important to note, however, that despite being easily the best exchange rate option, it would not be without difficulty to run smoothly. Specifically, to run any kind of foreign exchange rate mechanism – from a float to a managed float – you need foreign exchange reserves. For example, similar sized countries to Scotland, such as the Nordic countries, each hold on average £40bn of reserves. An independent Scotland’s per capita share of total UK reserves would be about £6bn, which would not be sufficient. To generate sufficient reserves would require an austerity programme.

The currency is likely to be very volatile in any transition period and this would have implications for trade. However, the macroeconomic benefits of a separate currency clearly vastly outweigh the microeconomic costs, although the transition period is likely to be very painful.

Join the euro: 1

As with a sterling monetary union, the eurozone is a one-size-fits-all monetary arrangement and therefore suffers similar problems to the sterling zone, such as an inability to address oil-driven competitiveness changes. For this reason, Norway is not a member of the eurozone and has a managed exchange rate regime.

Furthermore, since more than 70 per cent of Scotland’s trade is with the rest of the UK, capricious movements in the euro could be highly detrimental to trade as well. Europe is currently moving to a banking and fiscal union and the latter conflicts with the Scottish government’s objective of 100 per cent fiscal freedom. Presumably also prior to entry to the eurozone an independent Scotland would first have to have its own central bank and currency and satisfy the relevant criteria for joining the euro, which it is unlikely to meet.

Copyright The Financial Times Limited 2016. All rights reserved. You may share using our article tools. Please don't cut articles from and redistribute by email or post to the web.

More on this topic

Suggestions below based on Scottish Independence

Consequences of a Yes vote will be profound

In his 2011 book ‘Vanished Kingdoms: The History of Half-Forgotten Europe’, the historian Norman Davies writes: “That the United Kingdom will collapse is a foregone conclusion. Sooner or later, all states do collapse… Only the ‘how’ and the ‘when’ are mysteries of the future.”