Scotland's future exchange rate regime

I have not, until now, written anything about prospective Scottish independence. In part I admit this is because the vote is a long way off (18th September 2014), and the polls have consistently suggested that the Scottish people will reject independence. However if television keeps showing reruns of Braveheart who knows what might happen. What is clear is that macroeconomics, rather than distorted historical facts, is crucial to any informed decision.

Today the UK Treasury has published a detailed analysis of the choices an independent Scotland would face in deciding on an exchange rate regime. Partly because of pre-publication spin, but also because the document itself is very negative in tone, its arguments may be dismissed as propaganda. This would be unfortunate, because there are some real and serious problems that the paper identifies. So let’s not ask here whether independence is a good idea, but instead if the vote for independence is yes, what next? Throughout I will refer to the remaining UK after independence as rUK, rather than as the ‘continuing UK’ which the Treasury document uses.

The policy of the Scottish National Party is to retain the use of sterling (although previously it had talked about joining the Euro), rather than have its own currency. The debate about fixed versus floating rates, or the cost and benefits of currency union, are as old as macroeconomics itself. Yet what is happening in the Eurozone clearly puts a fresh perspective on this debate. It illustrates that the key issues are as much fiscal as monetary.

In terms of setting interest rates, existing arrangements could carry on almost as if nothing had happened. The MPC could continue to set monetary policy under a flexible inflation targeting regime, where the inflation target continued to be for the whole sterling union. There would be some changes in detail (external members could no longer be appointed just be the rUK Chancellor), but the MPC could remain as accountable to both governments as it is to the single UK government. This is one advantage of having a currency union of 2 rather than 17. The costs and benefits of this for Scotland would be the standard Optimal Currency Area issues, noting that the scope for migration between the two parts of the sterling union is quite high.

Scotland would inherit a significant proportion of UK government debt. So a key question is, would the Bank of England act as a Lender of Last Resort (LOLR) for that debt? As Brian Ashcroft notes, there is no way the UK government will allow the Bank of England to become sufficiently independent that it could refuse to act as a LOLR for the rUK government. So the Scottish government cannot be equal to the rUK government in this respect. If the Scottish government wants the Bank of England to act as a LOLR for Scotland, it has to persuade the rUK to allow it to do so.

Would it matter if it did not? Without such a provision, it is quite possible that Scotland might find itself in the type of bad equilibrium that the Eurozone periphery experienced in 2010/2012. They may find themselves paying a significantly higher interest rate on any new debt they issued compared to rUK, and this - or the threat of it - might restrict what they felt able to do in terms of fiscal deficits. (For a detailed discussion on this point, see Brian Ashcroft here.)

If the new Scottish government asked the Bank of England to act as a LOLR for its government debt, what price would the UK government ask in return? If the Eurozone experience is anything to go by, they might impose tough restrictions on Scottish fiscal policy - their own version of the Eurozone’s fiscal compact. This might reduce the risk of a market crisis, but the Scottish government cannot relish having rUK constantly monitoring and prescribing its fiscal decisions in the way the Troika currently does for some periphery countries. rUK might want to impose such conditions just to act as a LOLR for Scottish financial institutions, even if it did not do so for the government, on the basis that otherwise it could not be sure the Scottish government would be willing or able to pay for such support.

Would tight fiscal restrictions on Scottish government borrowing matter? In the longer term you could argue that, with exhaustible oil money playing a large role for a newly independent Scotland, it should be building up a sovereign wealth fund along Norwegian lines, in which case large budget surpluses would be the norm. In other words it should be choosing a tight fiscal policy in any case. The problem is one of transition. The UK economy is almost certain to still be very depressed at the end of 2014, and Scotland’s macroeconomic position in this respect is similar to the UK average, so it will clearly not be the moment for a sharp tightening of Scottish fiscal policy relative to rUK.

Is it inevitable that any sterling currency union would involve imposing a more restrictive fiscal policy on Scotland than it would experience without independence? In a previous post I outlined how the ECB could set conditionality for its LOLR role (OMT) in such a way as to avoid imposing an unnecessarily tight fiscal regime. I argued that they just need to be reasonably sure that the government will remain solvent, and suggested a way this could be done. The Scottish government could ask for a similar arrangement from the Bank of England. The arrangement I suggest requires that default would happen if the central bank believes the government is not solvent, so a significant default premium on Scottish debt would remain. (In contrast, LOLR would in practice be unconditional for rUK, so rUK would have a smaller default premium.) However the sterling equivalent of a fiscal compact, or worse the equivalent of Troika control, would not be imposed on Scotland.

The Scottish government might propose such an arrangement as an alternative to Eurozone type controls. It could argue, with some justification, that this arrangement was in rUK’s own interests, because the alternative policy of squeezing Scottish fiscal policy would damage rUK. It could note the harm that the current fiscal restrictions on the Eurozone periphery were doing to exports from the core, and overall political stability.

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.