News Column

Problems with sterling mean Plan B needed

July 7, 2014

Jeremy Peat; Jeremy Peat

This is one of those weeks when I wish that I could write three columns, as there are so many important issues which should be covered. But I must be selective and have decided that the issue topping the list in terms of importance is that of Scotland's prospective currency choices in the event of independence.

Over the past few weeks I have been poring over all the various learned contributions on this topic in order to produce a paper for Scottish Financial Enterprise and the David Hume Institute.

That paper - which is available on the DHI website - was discussed at an SFE/DHI seminar with an excellent panel and an informed and challenging audience. The discussion with the panel and the audience has helped to firm up my views.

To summarise my revised conclusions, there appear to be only (at the most) two realistic options available on the currency front - and one of those may turn out to be unobtainable. In my paper I discuss four options: (i) a formal sterling currency union, (ii) informal use of sterling, (iii) a new currency and (iv) adoption of the euro.

Closer examination suggests that informal use of sterling would likely prove either unfeasible or potentially disastrous; certainly a risk too far. Movement to the euro could prove a longer-term possibility, but it would not be available for the first several years of independence and thereafter the path to euro adoption could be long and arduous. So that leaves either a formal currency union or a new currency for a newly independent Scotland.

There are (at least) two major problems as far as a formal currency union is concerned. First, all three of the major political parties in the UK, which could jointly or severally form the UK Government after the 2015 General Election, have stated repeatedly they would not agree to such an arrangement under any conceivable circumstances. Second, if ever a continuing currency union were to be negotiated it would be likely to be on terms which, to quote the gentle understatement of the Governor of the Bank of England, require "some ceding of national sovereignty". The newly independent Scotland would have close to zero influence over the monetary policy set by the Bank; the Monetary Policy Committee would focus on the interests of the rest of the UK (rUK). At the same time, significant constraints would be imposed on Scotland's over-arching fiscal policy - presumably ruling out John Swinney's plan to increase public expenditure by three per cent per annum financed by increased borrowing - and also quite possibly on tax policies.

The great advantage of a continuing currency union would be the maintenance of currency stability with our major trading and economic partner - and no transaction costs on purchases or sales with this partner. On the balance sheet against this big positive, however, must be set the distinct risk that the macro policies, set in the interests of rUK, would become increasingly inappropriate for Scotland as the economies of the two nations diverged.

The SNP's White Paper effectively accepts that the continuing sterling currency union might be only a short-term solution, but what would follow? Would the financial markets decide that, even while remaining within a currency union, the uncertainties as to sustainability and what comes next would mean borrowing costs for Scotland would be markedly higher than for rUK? Would a currency union, even in the short term, involve (in the words of one commentator) "conditions that no self-respecting nationalist should be prepared to accept"?

So a continuing currency union may - rightly or wrongly - be ruled out by the next UK Government. Even if that government backtracks and enters negotiations, any agreement would involve Scotland ceding significant national sovereignty and facing macro- economic policies imposed from elsewhere which risk becoming increasingly inappropriate. Given these conclusions, I would suggest, over the next two-and-a-half months, much more attention than has been the case to date should be paid to the possible currency Plan B. That Plan B has to be a new independent currency for an independent Scotland.There are a variety of options for this new currency. Essentially, efforts could be directed to pegging its value as closely as possible to sterling, or it could be allowed to float free and find its own value in the international markets. (It might also be seen as a bridge towards ultimate entry to the eurozone.)

Pegging to sterling would yield the benefits of currency stability referred to within the currency union context. But this would involve constraining Scottish policies significantly to achieve and sustain that peg. Floating free would provide what Governor Carney has described as "a valuable shock absorber" taking some of the strain which would otherwise be taken by monetary and fiscal policies.

Clearly, this concept of a new currency is no panacea. Research for the Scottish Government last year by Dr David Skilling, and findings from numerous other authorities, confirm small independent countries, especially those with a major volatile and unpredictable income stream (like oil or gas), are required by the international financial markets to run tight macro-policy ships.

In no world of reality would the new fledgling state of Scotland be unconstrained on the macro-policy front. In the unlikely event of agreement on a currency union, severe constraints would be imposed from rUK. With a new currency the constraints would come via the markets. At least under this option the new government would be able to decide for itself in which directions it wished to head, and to work within market constraints as it saw best for the interests of the new nation.

Jeremy Peat is visiting professor at the Strathclyde International Public Policy Institute


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Source: Herald, The (Scotland)


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