This post considers some of the issues that would arise if Scotland were to vote in favour of independence. The timing of the referendum is not yet clear, and there are ongoing debates as to the actual questions to be asked of the Scottish people. This post only considers full independence, i.e. Scotland leaving the United Kingdom and becoming a separate sovereign country. Other proposals that stop short of full independence are also likely to be on the table, and I will return to these in a subsequent post.
One of the major arguments has been whether Scotland leaving the Union would in effect mean that the United Kingdom (UK) ceases to exist. The Scottish National Party (SNP) seems to think that it would have this effect, and appears almost gleeful at the prospect. But I concur with the writer of this paper from the Centre For European Reform (1999), who concluded that the principle of parliamentary sovereignty, which is fundamental to the UK's constitution (and historically one of the major areas of disagreement between England and Scotland), means that the Westminster parliament can simply change the rules. It would probably repeal the Treaty of Union and create a new Treaty redefining the UK as England, Wales and Northern Ireland: this is similar to what was done when Ireland was brought into the Union, and again when Ireland left it. It is completely wrong to assume that dissolving the existing Treaty of Union would destroy the UK parliament (which I think is what the SNP believe). Nor would it mean that the Westminster parliament would become the "English" parliament. Wales and Northern Ireland would still be represented there, although there would probably need to be fundamental changes to prevent them being swamped by the dominance of England.
As I am of the opinion that the Westminster parliament will have both the desire and the ability to ensure the continuation of the UK as an entity in the event of Scotland leaving the Union, I will assume in the remainder of this post that the UK would continue to exist as a union of England, Wales and Northern Ireland.
Much of the discussion around the economic case for Scottish independence has centred on its GDP and its claim to North Sea Oil. And much of the discussion around the political case for Scottish independence has centred on the Scottish people's historic and current grievances against the English. I don't propose to address those in this post, although they are serious matters. I want to look at the financial implications for Scotland, and in particular, the question of its currency. I appreciate that for many Scots this is a sideshow compared to their sense of injustice and their desire to run their own affairs, but I believe understanding the currency issue is essential if the Scottish people are to make an informed and rational decision on their future. If they make the wrong decision, Scotland could end up like Greece.
As I see it, the currency options for an independent Scotland are as follows:
- retaining sterling
- joining the Euro
- issuing a new Scottish currency
Each has significant economic and political implications.
1) Retaining sterling
There are in my view serious issues with Scotland retaining sterling. The relationship between the UK and Scotland would be fundamentally different from today. Alec Salmond's remarks the other day suggest that the SNP does not fully appreciate the extent of this difference, and this has been borne out in conversations I have had with members of the SNP. To them, sterling has historically been Scotland's currency and they don't see why they should have to change it - and indeed, as sterling is freely traded the UK cannot prevent them using it. The reality, though, is that if Scotland left the union it would also lose any right to issue sterling or control it in any way. It would in effect be using a foreign currency.
Adopting a foreign currency means giving up control of monetary policy to a foreign state. The value of sterling is controlled by the Bank of England through interest rate policy, base money creation and open market operations. At present, as a member of the UK, Scotland can reasonably expect to have its needs taken into account in the conduct of monetary policy - and indeed the SNP's 2011 manifesto contains a commitment to press for Scottish representation on the Monetary Policy Committee (MPC). But after independence Scotland would have no right to have its needs considered or to be represented on the MPC. It would simply have to suffer the consequences of the MPC setting monetary policy to suit the needs of the UK only.
The SNP argues that this is not significantly different from the present situation. But I'm afraid they are wrong.
Yes, the MPC sets monetary policy for the UK as a whole, not to suit particular parts of it. But the UK is a fiscal union. Monetary strains are offset by fiscal transfers, which in the UK are of the "shared taxation" variety: Scotland does not levy its own income and corporation taxes, but shares in the total "pot" of UK taxation. The formula by which Scotland receives back tax revenue in the form of a block grant is known as the Barnett formula. It is widely seen by English people as benefiting Scotland at the expense of England, and is one of the main reasons why Scottish independence is more popular in England than it is in Scotland.
An independent Scotland would levy its own taxes and would receive no money at all from the UK. It would still be in monetary union with the UK, but no longer in fiscal or political union. As we have seen in the Eurozone, when there is monetary union without fiscal union smaller countries suffer because monetary policy is inevitably set to suit the dominant economy. In the case of the Eurozone, peripheral countries have suffered catastrophic loss of competitiveness because monetary policy for over a decade has suited Germany but been completely wrong for them. In the case of the UK and Scotland, this imbalance would be aggravated by the fact that monetary policy would actually be set by the dominant economy, which isn't the case in the Eurozone. If Scotland chose to run a looser fiscal regime than the UK - which from the electoral dynamics seems very likely - it would suffer the same loss of competitiveness as peripheral countries in the Eurozone. Because it would not be in any sort of political union with the UK, Scotland would not suffer externally-imposed fiscal discipline as peripheral Eurozone countries are experiencing. But it wouldn't get any help either. It would no longer have the protection of the fiscal transfers it currently receives. And its banking system would no longer automatically have access to "lender of last resort" support from the Bank of England - and I suspect that if the Bank of England were seen to be supporting Scottish banks after independence, there would be a political storm from English people already angry about the extent of the support that Scottish banks received from the UK government in the 2008 financial crisis.
2) Joining the euro
Until recently, this was the SNP's preferred option, and it still remains their long-term policy - although in the conversation I had with Dundee SNP, they suggested that this might actually be indefinite.
The first, and most obvious question here is - as only EU members can join the Euro, would an independent Scotland retain its European Union (EU) membership, or would it have to apply for membership in its own right as an independent entity? There are differing opinions on this. The SNP assumes that Scotland would remain a member of the EU, but this stems from its belief that the UK would no longer exist and therefore the EU would have no basis on which to determine which of the four countries should inherit EU membership. I've explained above why I think this belief is mistaken and the UK will continue to exist. In my view the EU is likely to acknowledge the re-formed UK as simply a smaller version of the old UK - sort of Germany in reverse. But it is by no means certain that it would automatically recognise Scotland as an EU member separately from the UK. As the Centre for European Reform paper explains (op. cit.), accepting Scotland's membership independently from the UK would involve treaty amendment because the number of EU members is written into the treaties. Treaty amendment to increase the number of members requires unanimous agreement from all existing member states. I suspect that Scotland would formally have to apply for membership, but the ever-pragmatic EU would fast-track its application and attempt to waive the normal convergence requirements to get it approved quickly. There may be objections to this from existing EU members.
If Scotland retains EU membership, it would probably also retain the UK's opt-out regarding Euro membership, although it could apply for membership if it chose. However, if Scotland has to apply for EU membership, the EU leadership would be likely to make joining the Euro in due course a condition of membership.
Membership of the EU creates a problem if Scotland is still using sterling. The central banking model in Europe places the European Central Bank (ECB) as the "hub" of a system of national central banks. Scotland would have no central bank of its own but would not be represented or supported by the Bank of England. It could not meet the ECB's requirement for submission of gold and foreign currency (FX) reserves unless it established its own central bank and persuaded the UK to relinquish a share of its gold and FX reserves at the ECB. But that central bank would have no currency-issuing powers. Even Eurozone central banks can issue Euros!
Joining the Euro is fraught with problems. Convergence criteria are strict, requiring public debt/GDP under 60% and cyclical deficit no larger than 3% (structural 0.5% or less). If Scotland were to take on its share of the UK national debt, its debt/GDP would be about the same as the UK's and its deficit between 5% and 11% depending on how much of North Sea Oil revenues it was able to claim. It would have to experience significant GDP growth to reduce these to the level required for euro membership. If Scotland were able to negotiate taking a significantly reduced share of the UK national debt (perhaps as quid pro quo for relinquishing any claim to past North Sea Oil receipts) it might run close to the debt requirements. But even 100% of North Sea Oil receipts would not bring its deficit down to the 3% target.
Furthermore, Euro membership would not confer the fiscal benefits that membership of the UK does. It is not a fiscal union in any meaningful sense, and there are at present no plans to make it one, despite all the rhetoric from EU leaders. Scotland would receive no fiscal transfers as at present, but would be forced through sanctions and budgetary supervision to impose fiscal austerity even against the wishes of its electorate. And it is clear from recent events that the EU leadership expects non-Euro members to meet convergence criteria too. This is much tougher than anything Scotland has experienced in the UK.
Scotland should think very hard before abandoning the UK's full fiscal union for the half-baked and increasingly authoritarian Eurozone.
3) A new Scottish currency
The three largest Scottish banks already issue Scottish pound notes that are widely accepted both north and south of the border, although not legal tender. An independent Scotland could therefore simply declare the "Scottish pound" as its legal currency. What value this would have internationally would be difficult to determine since Scotland would have no "credit history", and if Scotland was carrying a fairly high level of inherited debt in relation to GDP and a largish deficit the currency markets might not be too keen on the new currency. They would be even less keen on it if Scotland increased its deficit to support the SNP's social and investment spending commitments. To prevent the Scottish pound collapsing, therefore, Scotland might have to peg it to one with a more solid history, such as sterling, the US dollar or the Euro (although I would suggest pegging a new currency to one on the verge of collapse wouldn't be too clever). The history of exchange rate pegs is not a happy one: economies have to be broadly equivalent economically for the peg to hold, as the UK's experience with the ERM shows, and if the peg is at an inappropriate exchange rate a serious trade imbalance can result. Holding a currency peg would require the same sort of fiscal convergence that retaining sterling or joining the Euro would need.
Having its own currency would at least give Scotland control of its monetary policy, although if the currency were pegged monetary policy would be largely defined by the need to hold the peg. In theory it wouldn't have to have a central bank (although this would probably be a requirement for EU membership). But its three currency-issuing banks would all be foreign-owned. Royal Bank of Scotland (RBS) is 84% owned by the UK government: Halifax Bank of Scotland (HBOS) is wholly owned by the English bank Lloyds TSB, itself 43% owned by the UK government: and Clydesdale is owned by the National Bank of Australia. Having all its currency issuance capability in foreign ownership may not be acceptable to Scotland's electorate, in which case setting up a central bank would seem to be essential.
There are also serious questions about the future in Scotland of its two biggest banks, RBS and HBOS. The SNP currently claims that Scotland should not have to accept any of the costs (paywall) of the bailout of those two banks: their arguments for this are that the banks were regulated in London, large parts of their retail operations are in England, and many of the activities that failed were south of the border or overseas. The counter argument is that although regulators bear some responsibility for failing to supervise banks properly, the failure of those banks was due to their appalling management. The view of many English people - and, it seems, some Scots - is that they can't see why England should bear all the costs of the mismanagement of Scottish banks, especially when it seems that some of their disastrous decisions were supported and endorsed by the Scottish government. The destruction of a major English bank (NatWest) by a Scottish megalomaniac still rankles with many English people, and the fact that they are being expected to pay for this adds insult to injury.
Personally, I don't think the fight is worthwhile. The solution is easy. If Scotland refuses to accept any responsibility for the cost of bailing out Scottish banks, then it should not have any share in their ownership. The UK government should retain its current stake in both banks, and return them to the private sector in due course. Scotland would have no claim on any profits from their privatisation. I would also personally like to see the UK government repatriate the headquarters of RBS to London and rename it NatWest, in recognition that it would be a UK-owned bank with 90% of its operations in the UK.
There are no simple solutions to Scotland's currency conundrum. Economic convergence and some surrender of monetary and fiscal sovereignty seems inevitable under each scenario, although issuing a new currency would at least give the possibility of genuine financial independence once the credibility of the new currency was established. But whichever currency alternative is adopted, deficit spending by an independent Scotland immediately after independence would carry terrible economic risks because of the inflexibility of any form of currency peg and the negative view of sovereign deficits that bond and currency markets tend to have. In my view, therefore, current SNP spending plans would not be sustainable post-independence - which begs the question why they are apparently sustainable now. Maybe there is some truth in the prevalent English belief that Scotland is subsidised by England?
And finally, I question what, in a world where countries and corporations are increasingly interconnected and interdependent, "independence" really means. Can any country truly be said to "run its own affairs" any more? Or are nation states in reality subservient to the demands of supra-national organisations, international markets and multinational corporations? Across the world, the drive is for nation states to band together and form economic unions as a response to increasing globalisation. Scotland's demand for independence seems to run counter to this. But as the SNP wants a future in a different kind of union, namely the EU, I wonder whether "independence" is really what they are asking for, or simply decoupling from England and the political system that they hate? And would this give them real economic benefits? For me, the economic case for Scottish independence is not made, and the currency issue appears fatal.
If the call for Scottish independence is simply based upon ancient grievances, current injustices and dislike of the union as currently consituted, surely it would be better to address these issues and have a sensible debate as to how the union could be reformed to suit all its members better? For although Scotland can leave the United Kingdom, it cannot leave the British Isles. England and Scotland still have to coexist peacefully.