Following former Bank of England Deputy Governor Brian Quinn’s paper slamming the SNP’s plans to keep sterling as “fundamentally flawed”, CALUM CRICHTON rounds up what the experts have to say on the SNP’s currency proposal.
The paper concludes that the concept of a shared system of supervision and crisis management is seriously – perhaps fundamentally – flawed. The weaknesses would increase during the post-independence transition period. Combine this with the uncertainties around Scotland’s use of sterling and you’ve got higher prudential requirements for our financial institutions, requiring a reconsidered corporate structure.
I have previously considered the currency options that would be open to an independent Scotland before, but following Brian Quinn’s paper, now seems as good a time as any for taking stock of what the experts say about the SNP’s currency proposal. Many cast doubt on how much ‘independence’ Scotland would actually gain by keeping sterling, concluding them to believe a separate currency would be Scotland’s only realistic option.
Mark Allan, UK Economist at AXA Investment Managers and Former Bank of England Analyst
An independent Scotland almost certainly means a new currency. Continuing using sterling would involve the surrender of fiscal sovereignty, rendering independence almost redundant given the Scottish Parliament already has control of domestic policy.
Dr Angus Armstrong, Director of Macroeconomic Research at the National Institute of Economic and Social Research
If the Scots vote for independence it is likely that they will take sterling as their currency but no longer have a fiscal union. The currency choice is appropriate from an optimal currency perspective. However, assuming a favourable settlement on future oil revenues the fiscal debt is likely to be 70 per cent of GDP and estimates of recent fiscal and current account deficits have both been around 4 per cent. Scotland would be required to have some additional fiscal headroom to ensure reasonable borrowing costs. An independent Scotland is therefore likely to find the implicit constraints on economic policy, especially fiscal policy, are even more restrictive than the explicit ones it faces as a full part of the UK.
Brian Ashcroft, Professor of Economics at the University of Strathclyde, and Editor of the Fraser of Allander Institute Economic Commentary
The BOE and the rUK government would require the Scottish government to observe an agreed set of fiscal rules which would likely cover limits on the scale of borrowing, the size of the primary budget deficit in relation to Scottish GDP and the level of Scottish government debt to GDP. The demands from the rUK government could be quite restrictive.
Dr David Comerford, Postdoctoral Researcher in Economics at the University of Stirling
The asymmetry between Scotland and rUK causes real problems for any proposed Sterling Union. With asymmetrical parties, not only are the benefits from the OCA unevenly split and weighted towards the smaller party, the moral hazard costs are split and weighted towards the larger party. If Scotland received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, and its citizens would eventually pay 10% of the costs of providing these resources. However, if rUK received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, but its citizens would eventually pay 90% of the costs of providing these resources. There is therefore a clear incentive for Scotland to put itself in a position where it is likely to need central bank support, whilst there is no great incentive for rUK to put itself into a similar position. The problem of moral hazard for Scotland is therefore exacerbated and rUK is likely to recognise this in evaluating the costs and benefits of a Sterling Zone.
If a Sterling Zone does provide net benefits overall, then it may be that the asymmetry between Scotland and rUK scuppers a project which could in principle be mutually beneficial. This is an example of a tragedy of the commons situation in which the incentives faced by the parties mean that a valuable resource is rationally squandered. In summary: the benefits of an Optimal Currency Area likely mainly accrue to Scotland due to asymmetry; and the higher costs of moral hazard mainly fall upon rUK – again due to asymmetry. If Scotland were to conduct a cost benefit analysis of the value of a Sterling Union then it might likely agree that it was the policy to pursue. If the rUK were to undertake the same calculation, they are likely to reject the policy. This seems to be consistent with the campaign positions that we see.
Stephanie Flanders, BBC Economics Editor
It’s not entirely plausible that Westminster would turn its nose up at a currency union with Scotland…but nor is the idea that Scotland could win significant economic freedom as an independent country – without giving up anything significant in return.
Sir John Gieve, former Deputy Governor of the Bank of England
If a new Scotland wanted to have a formal currency union, it would need to agree the terms with the remaining UK government. I would expect that government to drive a pretty hard bargain. For example, it would want to constrain how much the Scottish Government borrowed.
Andrew Goudie, former Chief Economic Adviser to the Scottish Government and now an adviser to the principal at the University of Strathclyde
What is probable is that any UK government is likely to seek an agreement that sets limitations on the ﬁscal aggregates – and the associated ﬁscal deﬁcit and debt ﬁnancing – to protect its macro-economic policy and safeguard it from adverse market reactions. Within this picture, the role of the Bank of England within a sterling monetary union would seem to be one of the most critical elements to be understood were constitutional independence to be adopted.
Foremost are important questions relating to its legal status, its governance and its potential role in support of Scottish Governments and Scottish financial companies – both those of strategic importance to the redefined UK and those that are not.
An independent Scotland may see major beneﬁt in securing these continuing services from the Bank of England. But, if it did and were, therefore, motivated to ﬁnalise such an agreement, the UK would be powerfully positioned to secure the conditionality that it deemed desirable for the stability of its macro-economic objectives, a desire only reinforced by the recent experience of the eurozone. Indeed, it is not difﬁcult to envisage a UK government seeking an agreement in which wider economic and ﬁnancial conditionality is determined.
From the perspective of micro-economic policy, while an independent Scotland would notionally have full powers over taxation policy, what degree of freedom would there be to exercise those powers?
Many have argued that the redefined UK government would have a key self-interest in preserving the stability and sustainability – and indeed prosperity – of the Scottish economy within a sterling zone, and, given the degree of integration of the two economies, this must be correct.
However, the redeﬁned UK would equally have a major interest in preserving its competitiveness. It would, therefore, seem highly probable that the UK would seek an agreement that incorporated signiﬁcant safeguards for the UK economy. While it is unlikely that the redefined UK would seek tax harmonisation throughout a sterling monetary union, it seems improbable that beggar-thy-neighbour tax competition would be accepted on any substantive scale.
DeAnne Julius, founder member of the Bank of England Monetary Policy Committee and has served on the Bank of England Court
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.
John Kay, Visiting Professor of Economics at the London School of Economics, and former member of the Scottish Government’s Council of Economic Advisers
The tough negotiations would be over fiscal policy. The central difficulty is the asymmetry in the size of the two countries: rUK – representing 91.5 per cent of the population of the monetary union, and a similar fraction of its output – would demand oversight of the borrowing and expenditure levels of Scotland.But it is impossible to imagine rUK conceding similar – or significant – oversight of its own fiscal policies to a Scottish state that made up 8.5 per cent of the monetary union.
If I represented the Scottish government in the extensive negotiations required by the creation of an independent state, I would try to secure a monetary union with England, and expect to fail.
Ronald MacDonald, Professor of Economics at the University of Glasgow, and Monetary Adviser to the International Monetary Fund
If Scotland were to become an independent nation it would be a net exporter of hydrocarbons whereas its near neighbour, RUK, would remain a net importer of oil. Hence if there are shocks to the price of oil, which there are bound to be, these would be classified as asymmetric shocks between the two areas. Furthermore, common shocks are likely to have an asymmetrical effect on output and employment in Scotland relative to RUK since the industrial structures of the two areas is not the same.
By failing to recognize these crucial issues, the Scottish Government’s exchange rate proposal cannot be a long run solution to the needs of an independent Scotland. And since it cannot be a long term solution neither can it be a short-term solution since expectations exert such a powerful influence over exchange rates and other asset prices that the long term becomes the short term very rapidly indeed.
To avoid the potentially unpleasant consequences on employment and output of asymmetric and common shocks Scotland would need an independent currency and this currency would need to have some flexibility to absorb the shocks likely to buffet the Scottish economy.
Rod MacLeod, Banking & Finance Partner at Tods Murray
An independent Scotland would most likely be the junior partner in any currency union with the rest of the UK, and therefore would be subject to fiscal oversight from the rest of the UK. So they would look at things like public spending, public borrowing, deficit, taxes. In any currency union, given the respective sizes of an independent Scotland’s economy and the rest of the UK, it’s inevitable that there would be more control on the UK side as opposed to an independent Scotland.
Gavin McCrone, Professor of Economics and former Chief Economist at the Scotland Office
If the Scottish Government wanted the Bank of England to continue as lender of last resort, it is most unlikely that this would be acceptable either to the Bank or to the government of the rest of the UK, unless it had oversight of Scottish fiscal policy and the right to withdraw from that role if it was not satisfied. If Scotland had its own central bank, as Ireland has since 1943, for it to be a credible lender of last resort to both the Scottish Government and financial institutions, it would have to be able issue currency, as the Bank of England has been doing in the present financial crisis. That implies a separate Scottish currency and, while that currency could be pegged to sterling, there would always be the possibility that its exchange rate could be altered either up or down.
So there is much that would need to be decided. If Scotland were to go down this route, my own view is that it would probably be best to have a separate central bank and a Scottish pound, which could be pegged to sterling or indeed the euro, depending on circumstances. But even so the Scottish Government still needs to explain how it would use the additional levers it would have to achieve a better performance from the economy.
Iain McLean, Professor of Politics at the University of Oxford
If sterling continues to be used in Scotland, the Bank of England could only be required to take into account Scotland’s economic conditions in setting monetary policy if this were made a condition of the independence treaty in the post-referendum bargaining. I cannot see that Scotland would have any lever over the RUK to force it to make this a condition.
Iain McMillan, Director of CBI Scotland
One thing we can be clear about is that if Scotland secedes from the union, the Government of what is left of the United Kingdom will look after the interests of that part of the UK—and rightly so. They will not look after Scotland’s interests. Therefore, that is where they will come from in any negotiation such as this. Clearly, from our point of view, we would like Scotland to participate as a member of the Monetary Policy Committee. However, it is very difficult to see how the Government of a foreign country—that is what England, Wales and Northern Ireland will become—will have any interest in being a lender of last resort to a bank based in Edinburgh.
Charles Nolan, Professor of Economics at the University of Glasgow
The Treasury analysis of the currency options facing an independent Scotland highlights the complexity of what’s involved. The preferred option of the Scottish Government is to do a deal and establish a formal Sterling zone. But it takes two to strike a deal and it now seems that a deal over a Sterling zone will be difficult to achieve.
The argument that it would be in the continuing UK’s interest to form a Sterling zone because Scotland contributes to the UK balance of payments loses force when one recognizes that the Pound is a floating currency. All that is likely to happen if the continuing UK loses those foreign exchange revenues is that the pound falls, boosting exports and curbing imports until a balance is one again restored. Balance of payments constraints only matter when you cannot adjust your exchange rate as Greece is currently finding.
The argument that we trade a lot with the rest of the United Kingdom, and vice versa, is true and that is why having a single currency is a good idea. But countries sharing a currency whilst operating separate fiscal policies face two difficult issues; they don’t help insure one another when things go wrong, and they can infect one another if one runs up excessive debt. Again, these elements are apparent in the Euro area today. That is why the euro area is pushing hard to establish something close to a fiscal and banking union.
It seems likely that, in the event of a vote for independence, at a minimum the continuing UK would want powers to intervene if necessary in the fiscal policy of Scotland in order to protect Sterling. It also seems likely that such powers would raise fundamental issues of sovereignty such that they would be rejected by the Scottish Government. There is therefore real uncertainty about what a vote for independence would mean. Uncertainty over questions of currency can be highly destabilising; they can lead to reduced investment and capital flight.
John Nugée, Senior Managing Director at SSgA’s Official Institutions Group, and former Chief Manager of Reserves Management at the Bank of England
It is now well understood that setting up such a monetary union requires a degree of co-ordination of fiscal and other policies which is not easy for sovereign states to agree to—and certainly won’t be easy for a newly independent Scotland to agree to, since the whole purpose of becoming independent is to free themselves from interference from London!
Robert Rowthorn, Professor of Economics at the University of Cambridge
It [Scotland] might have independence with regard to what its tax rates would be, for example who it would levy taxes on and whether it would have a lower corporation tax or a higher income tax et cetera. But in terms of fiscal deficit, broadly speaking it would have rather severe limits on what it could do [if it kept sterling].
Rupert Soames, Chief Executive of Aggreko plc
Quite a lot of the promise of independence lies around the idea that we can have a different tax regime north of the border. This seems highly unlikely, either in the context of being part of the euro or having monetary policy effectively controlled by the MPC in London. In either case, there will have to be a Maastricht with straps on. We have already discovered that Maastricht was not tight in enough in its rules around deficits and the like to be able to avoid some sort of disaster with the currency.
I have enormous doubts about whether the EU would welcome another state joining the euro, particularly one with the fiscal position that Scotland standing alone would have, so I think that it would probably have to be sterling. I just think that what you will get is a very rigid structure applied to the Scottish economy and fiscal position, which will make the whole thing fairly pointless because they will not be able to change the tax rate very much within that structure.
Martin Wolf, Chief Economics Commentator at the Financial Times, and a member of the UK Government’s Independent Commission on Banking in 2010-2011
Remaining within the sterling area for an unknown period, as the Scottish National party suggests, cannot be a unilateral decision. True, one possibility would be for Scotland to adopt sterling as its currency, without access to the Bank of England. Yet, in that case, neither its financial institutions nor its government would enjoy a lender of last resort, with lethal consequences in a crisis – as we have seen in the eurozone.
The alternative would be for Scotland to use the Bank of England as its central bank. In that case, the residual UK, whose central bank would continue to be the Bank of England, would need to oversee Scotland’s fiscal management. Otherwise, the people of the residual UK would be writing blank cheques. Since that would be unacceptable, Scotland would enjoy neither monetary nor fiscal independence.
This, then, connects to a third big question: the future of Scotland’s financial industry. Because of its full integration inside the UK, Scotland is home to a number of very large financial institutions that do most of their business elsewhere, particularly in the rest of the UK.
The Scottish government would not have the fiscal resources to back these entities if they got into difficulty. In fact, it would be even more vulnerable than pre-crisis Iceland. Having adopted the proposals of its Independent Commission on Banking, the government of the residual UK would presumably want retail banking to go through independent subsidiaries regulated by the Bank of England and backed, in the last resort, by taxpayers of the residual UK. Under European law, it would be possible for a Scottish-based bank to branch into the rest of the UK. But depositors must be made aware that only the Scottish government backed their deposits. In practice, companies that do the bulk of their business in the residual UK are likely to move headquarters there.
The Scots needs to understand that independence would deprive them of the benefits of pooling resources and bring real costs. They cannot assume they would be able to remain inside the sterling area or retain anything like their present financial sector. They can also not assume they would sustain the UK’s credit rating and be able to enjoy their current level of spending either, even if they were to receive what they see as their share of North Sea revenue.
Simon Wren-Lewis, Professor of Economics at the University of Oxford
The problem is that when it comes to fiscal policy, the UK is an awfully long way from being enlightened. Just as it thinks the current UK recession has nothing to do with its own fiscal regime, it is unlikely to be sympathetic to concerns from Scotland about imposing tight fiscal policy there. It would recognise the harm that a Scottish default could do to rUK, but its response will be to impose tough fiscal restrictions to avoid that happening, even if it does not agree to act as a LOLR.
The real problem for Scotland is that, in forming a sterling currency union, it will be dealing with a government that thinks like Germany. What is worse, although Germany can sometimes be persuaded to go against its austerity instincts for the sake of European unity, after an independence vote rUK is unlikely to let its heart strings be pulled in a similar way!
The problem for Scotland is that the rUK can provide something that in fact costs it very little, but the absence of which would cost Scotland a great deal, so rUK will be able to ask for a high price. Unless the new Scottish government is prepared to pay for a Bank of England LOLR role with some of its oil revenues, it may find it has nothing to bargain with. If no agreement can be found, the Treasury paper is quite right to conclude that using sterling unilaterally would not be attractive for Scotland. So rather than accept damaging fiscal restrictions, the new Scottish government may end up with its own currency after all.
There is no doubt that Scotland could become a politically independent nation, if that is what Scottish electors decide they want in next year’s referendum. However, it is not clear how much economic independence Scotland would achieve. If Scotland kept the pound as its currency, then Scottish monetary policy would be largely determined in London. Also, taxes and spending might need to be tightly constrained, to keep the budget deficit in line with that of the remaining UK.
Behind these judgements is the likelihood that the Bank of England, and hence tax-payers in the remaining UK, would need to offer a lender of last resort facility, and would also need to stand ready to honour debt issued in the past by the UK government. Such pledges would surely only be given if the rest of the UK government retained a high degree of control over Scottish economic policy.
Most testing for Scotland’s future would be the question of its currency. Mr Salmond’s hopes of joining the euro have soured—for now he plans to stick with the pound. Yet the euro zone has amply demonstrated the dangers of entering a monetary union without fiscal union. Soothing niceties from Cheshire-cat politicians no longer reassure bond markets—Scotland would pay a premium for being part of a monetary union that could break. It would have no central bank, no monetary freedom and limited fiscal autonomy.
Financial Times Editorial
If things ever get as far as having to decide on a monetary union, the political considerations will be as important as the economic ones. It is hard to imagine the rest of the UK inviting a breakout nation a 10th of its size into a truly equal partnership on monetary affairs. A demand for fiscal control over the new northern neighbour may be necessary to justify a BoE risk of having to lend in the last resort to a profligate Scottish government. A bigger risk is having to lend in the last resort to banks. That privilege would not be granted without tight cross-border control on financial regulation. A currency union cannot work without it, as Europe is finding out the hard way.
ING Commercial Banking
The key lesson we have learned from the Eurozone crisis is that monetary union requires greater fiscal coordination, not less. Therefore a UK-Scottish currency union and full Scottish economic independence from the UK is not going to be possible. If the UK were to agree to currency union, we assume there would be a raft of fiscal rules introduced, including the harmonisation of taxation levels and government spending limits. This could curtail the policy ambitions of any future Scottish government. Furthermore, by continuing to use sterling, Scotland would have no control over monetary policy since the Bank of England would be setting interest rates (and the level of quantitative easing) based on the UK economy and not the Scottish economy.
The Institute of Chartered Accountants in England and Wales
If Scotland kept sterling, the rest of the UK would be likely to require robust fiscal rules on risk exposure from the beginning of any new constitutional arrangements. Given current experience of the problems in the euro zone and its impact on the UK, it seems likely that an independent Scotland would be extremely vulnerable to economic problems in the UK, given that the rest of the UK is currently and will probably continue to be its largest trading partner, whereas the rest of the UK is likely to be less vulnerable if economic problems were confined to Scotland – especially if Scotland adopted a different currency.
As I’ve argued many times before on my own blog, the question is not simply whether Scotland should be independent but whether Scotland could be genuinely politically and economically independent. Would it have the autonomy to set the level of taxes and public spending that it would like, for better or for worse, as the SNP suggest? Or would it instead face a much higher degree of economic and financial constraints that it does at present? The evidence points to the latter.