As the debate continues about Scotland's choice of currency post independence I notice a disturbing tendency to assume that the issue is one that can be resolved politically. Get a currency deal with the UK Treasury and everything will be ok; just another one of the agreements that would have to be made about splitting institutions following independence.
This is fundamentally misconceived.
The adoption of a currency post-independence is not simply a process issue that once negotiated can be set aside. The currency choice sets a critical parameter for the conduct of Scotland's economic affairs after independence. As I noted here
This means that Scotland would not be equal to rUK. The BOE would be the rUK's central bank performing some necessary financial and monetary stability functions for the sterling union. There would be no Scottish central bank. There would be a common nominal interest rate across the sterling union. The BOE would act as "lender of last resort" to all banks in the monetary union, including Scottish banks, but would do so at 'penal' or above market rates. It would also require Scottish banks to satisfy UK financial stability rules, implementing the proposals of the Vickers' Commission and so on. The BOE would need to do this as part of its objective of ensuring financial stability in both rUK and the wider sterling union. The Scottish government would be issuing its own bonds but in sterling. It would effectively be borrowing in a foreign currency and would have no ability to print money. Accordingly, the markets are likely to demand a higher yield premium on Scottish 10 year and 30 year bonds than rUK Treasuries and present UK Treasuries.
Further, on the fiscal position of an independent Scotland that adopted sterling I noted
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. Accordingly, the Scottish government might not observe these rules and the financial markets would be uncertain what would happen if Scotland, being unable to print or change the value of its own currency, defaulted on its debt. We have seen the difficulties this has caused with the financial markets in their uncertainty about whether the ECB will support member states by buying their bonds. Again the result would be Scotland's sterling denominated bonds trading at a premium to present UK Treasuries.
This position is almost identical to that outlined by the National Institute for Economic and Social Research yesterday. The requirement that Scotland adopt certain fiscal rules is the 'price' that Scotland would have to pay for the BOE continuing to be lender of last resort to Scottish banks and enjoying the benefits of stable international currency. The BOE and the rUK government would desire Scotland to adhere to the fiscal restrictions because there would be a risk that Scotland might experience a deteriorating balance of payments and fiscal position with an increasing risk of default on its bonds. All of that could de-stabilise sterling.
The view that the BOE can be viewed as separate from the rUK government in matters such as this is risible. The ultimate guarantor of the BOE is the UK tax payer. And, in the event of Scottish independence it will be the rUK tax payer alone.
It is further argued by some that the problems of the Eurozone were caused by fiscal irresponsibility and that since the Scottish government will prudently manage its finances none of the above is really relevant. But this is a false premise. The problems within the Eurozone are essentially due to the growth of current account imbalances with rising deficits in the periphery and rising surpluses in the core - essentially Germany - see this earlier post.
So, it is possible to envisage a situation in which a post-independence Scotland might attract significant capital inflows that flow largely into property, non productive investments and domestic consumption. The process would tend to fuel rising domestic prices i.e. inflation, in Scotland if the capital flow did not raise productivity. Hence there would be a rising real exchange rate, deteriorating competitiveness and a worsening trade position. As jobs are lost and companies close, the Scottish fiscal position would deteriorate and this would be worse if there was a sudden stop in the capital flow as happened in the Eurozone. The point here is that a Scottish government with prudent fiscal intentions might still end up in dire fiscal position which would make their bond yields rise and which could pose a threat to the stability of sterling.
All of which leaves me with one final myth: the view that Scotland wouldn't be able to run an independent fiscal policy if there was a requirement by the BOE and the rUK that Scotland operate under a set of fiscal rules. Indeed, within a monetary union a sub-sovereign state only has fiscal policy with which to manage aggregate demand in its economy - see the respected macroeconomist Simon Wren Lewis on this. In the above example a prudent Scottish government would have begun to tighten fiscal policy as domestic prices started to rise. Something which if it had happened in the periphery of the Eurozone before the credit crunch would have mitigated first the balance of payments problem then the fiscal problems that they are currently confronting; as would fiscal expansion in Germany now.
An independent Scotland would need to use fiscal policy in a sterling monetary union as the only instrument directly available to it to manage aggregate demand. It would, however, have to do so within a broad fiscal framework set by the BOE and the rUK government.
Brian: I am not an economist so forgive any naivety here as I try to understand the argument. It seems that the debate about the economics of independence can be roughly divided into a debate about what one might call start-up costs and then a debate about how an independent Scotland would fare once up and running, as it were. If I've understand some of the other things you have been saying aright, you accept that an independent Scotland could be even more prosperous than in the UK, as with other small north European states; but the key difference is they have been independent for some time. If the birth of an independent Scotland was a difficult one, economically, then it might set Scotland off an a track of lower growth and prosperity than rUK rather than parity or better. Is that right?
Does that mean, then, that you think if the first few years of an independent Scotland were even just satisfactory, on the economic front: the fiscal deficit/GDP remained below the rUKs, as it mostly has been recently, Scotland stayed inside the rules set by BoE without having to introduce austerity measures, there was no flight of capital, business waited to see how things went etc. If this lasted say 5-10 years (I think the Irish Free State and Australia used sterling for about this period before launching their own, sterling-pegged, currencies) is it your view that the prospects would be good for an independent Scotland being at least as prosperous as in the UK?
If so, the debate seems to come down to the likelihood of a traumatic birth yes? I can't follow the technical arguments re currency very well but I don't really see why a traumatic birth is likely. Volatile oil prices while the country has no reserves and no financial tack record as yet, that would be a problem. But the likeliest cause of volatility seems to be Middle East troubles: Israel attacking Iran, say, and isn't that likely to put prices up?
Or is the worry that unionist Scottish business people would pull out without waiting to see how we fared, or that rUK would pull up the bridges, a bit like the pre-1707 situation? Whatever the economic plausibility of that, it would be a strange line for unionist politicians to sell to the Scottish people: Scotland has every chance of being a prosperous success in Europe, except we are going to do our damnedest to sabotage it!
Alan
Posted by: Alan Weir | 05 February 2012 at 05:37 PM
Please forgive my lack of knowledge as I find some of the more intricate workings of government and politics rather daunting. However there are some things that I occasionally pick up on.
It does make me laugh when hearing talk of Scotland keeping the pound and how they would go about this arangement. Also the assumption that Scotland would struggle as an independant country. Others have already pointed to our Scandanavian neighbours as examples, but I would also like to point out the fact that Guernsey, Jersey, and Isle of Man all have their own printed currency based on the Pound, and they too have independant governments. Also they are part of the British Isles but are not part of the European Union. They do rather well don't they?
Another point that is brought up is that of Scotland having to re-apply to be part of the European Union. If this were the case then the "New UK" would also have to re-apply as a different entity from the one that had negotiated it's membership previously.
Posted by: Mark Cowan | 08 January 2014 at 11:05 PM