Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 23 April 2013

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.


  1. Nice post. But given that the Scottish banking and public sectors (inherited portion of UK PSND) both have external Sterling denominated debts, it would take several decades for them to be able to extricate themselves from Sterling, if that is even feasible at all.

    And for what?

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  2. 1. Do not see the advantage for the UK to have somebody infering with your monetary policy.

    2. Legally it is a mess. Scotland will be obliged to join the EZ. It will likely be obliged to join the banking union full scale.
    As EU membership will not be from day 1 the EU conditions will still not be known while the Pound/BoE conditions should already be working.

  3. I think that there is a parallel here with the history of the Irish currency post-1922. Most of Ireland's trade was with the UK, and having an Irish Pound with one for one parity with Sterling was seen as a solution that offered stability.

    However, there were problems in that a small economy sharing a currency with a large economy tends to inherit the larger economy's inflation rate, which was a problem for Ireland in the Seventies.

    And then, the larger economy can make policy decisions that are inconvenient for the smaller, such as the UK's decision to stay outside EMS when Ireland joined. Sterling appreciated strongly in the Eighties, and in the end Ireland had to drop parity with Sterling, and the Irish Pound traded as low as 80p Sterling - in some ways the ERM story told backwards.

    I'd say that if Scotland does vote for independence - as a part Scot I hope they don't - adopting Sterling or the euro will present more or less the same problems of intensive supervision the periphery are currently experiencing. But if a Scottish Pound is adopted then Scotland can change its monetary policies as circumstances change, just as Ireland did.

    It won't be a free lunch, since of course more than a currency is involved in running an economy. Personally, I'd be more worried about RBS and defence related Scottish industry than about the Scottish Pound.

  4. A very interesting post. As a Scot who lives in England, I have doubts that Scotland will vote for independence. However, as you say, we should be prepared for that eventuality.

    I would like to ask some questions based on your post. I do not know the answers so am asking out of ignorance rather than challenging your views.

    Scottish independence could be viewed as one of two analogies. It could be seen as a divorce. In that case, assets and liabilities would be shared out in a way that is fair to both parties. Alternatively, it could be seen as an errant child leaving home. In that case, assets and liabilities would stay with the parents. The child would start out with a clean sheet.

    For EU membership, the UK government seems to see Scottish independence as the errant child analogy. rUK would continue to “own” the UK’s EU membership. Scotland would start with a clean sheet and would have to apply for EU membership. This would probably mean that, on entry, Scotland would be required to sign up to the Euro. The Scottish government, however, uses the divorce analogy. Both ex-partners would have a part ownership of the existing EU membership and both would start on an equal footing. They assume that both ex-partners would retain EU membership. Scotland would then have more freedom on whether or when to join the Euro.

    For national debt, the UK government changes the analogy to a divorce. Now Scotland is a partner which must take on its share of UK national debt. The Scottish government is more consistent. It sees this aspect as a divorce too so agrees about taking on a share of the debt. In your post, you seem to assume a divorce.

    For ownership of the currency and the central bank, the UK government analogy reverts back to the errant child. rUK would “own” the currency and the central bank. Scotland would have to ask permission to use at least some aspects of these things. I am not clear what the Scottish government position is here although I assume it would stick with divorce. You seem to assume an errant child.

    If I have understood correctly, the UK government and you are mixing analogies. Scotland should take on its share of national debt. However, the Scottish government should then ask permission from the rUK government to have any say in the running of the currency in which that debt is denominated. That seems wrong to me.

    If we follow the divorce analogy consistently then Scotland should take its share of national debt but must have an equal say in the running of the currency and the central bank. Otherwise, Scotland would be taking on debt in a currency over which it had little or no control. rUK and Scotland would have to negotiate a relationship which would revert to something like the “devo max” option which most Scots would probably prefer anyway i.e. create a UK version of the type of governance which the Euro-zone would need in order for the Euro to work properly.

    If we follow the errant child analogy consistently then rUK should have exclusive ownership of the currency and the central bank but I can’t see why Scotland should agree to taking any share of the UK national debt irrespective of what currency Scotland adopted (unofficial use of pound, own currency or Euro).

    Here are my questions to you:

    1) Which of my two analogies do you think is most appropriate, or do you see an alternative analogy?

    2) Do you agree with the apparent inconsistencies of mixing analogies and, if so, how would you resolve them?

    3) Are there any precedents for currency and debt sharing after a declaration of independence in advanced/European countries? For example, when Estonia split from the USSR, or when Czechoslovakia split in two, or when Ireland split from the UK? In particular, did any errant children take on part of the debt of the parent without an equal say in running the parent currency and central bank?

    1. There is always the line running through the Scottish independence vote discussion that forgets that the rest of the UK has a choice in the matter.

      If the rest of the UK doesn't want to be in a currency union with the Scots - and given that would require the rest of the UK parliament to give up its currency sovereignty that is almost certainly the case - then there is nothing the independent Scots can do to force that to happen.

      The rest of the UK can simply change its currency arrangements as required - even if that means adopting a 'new pound' and redenominating.

      If that means removing the power of the current Bank of England to issue the currency, then that is what will happen.

      The lesson of the Eurozone is clear - one parliament, one currency. If Scotland wants to be sovereign then it needs its own scrip - and with oil wealth helping with the external trade issues it shouldn't be so reticent in pushing forward with that idea.

    2. I don't see your point here. Why should the analogy be applied consistently across two different institutions, with different rules?
      The debt was has arisen because the government used it either fund capital projects or current expenditure. Both were benefits or are continuing benefits, so the debt goes with the assets. If you don't want the debts, don't take the assets (this isn't intended to be a practical suggestion, the Treasury isn't likely to repossess a bridge).

    3. I really can't follow your argument here. The requirement to negotiate EU membership is an EU requirement. It's not the UK leaving the EU - if only - but Scotland leaving the UK and becoming a new country. A new country has to apply to join the EU. Not rocket Science.

      Dividing up UK assets and liabilities is a UK issue, not an EU issue - at least not so far - so that would be a separate negotiation.

      That the debt Scotland would inherit would be denominated in Sterling is a complication, but it's one that can be managed. The debt would be English law debt, so Scotland would be unable to impose haircuts without defaulting, but hey, Independence has its price, no?

    4. Neil Wilson,

      Yes of course rUK would have a choice on whether to enter a currency union. That is the point of Osborne’s intervention this week.

      From Scotland’s perspective, voting for independence and then asking to form a currency union seems like a poor strategy. Scotland already has a currency union with rUK. Why would it vote away that union only to immediately try to negotiate it back? I don’t understand Salmond’s strategy. If Scotland wishes to retain the pound but to have the maximum practical political freedom within that currency union, it would be a much more effective strategy to push towards “devo max” from the inside of the UK. It would be much harder for rUK to resist. I doubt that Scotland will vote for independence, so I expect that in a couple of years the strategy will revert to a push for “devo max”.

      Jon Livesey/Anonymous,

      The SNP see the situation on debt differently from you. Here is John Swinney (Finance Secretary):

      Mr Swinney said: "What the Treasury's paper is designed to do is to make things sound as difficult and obstructive as possible. I don't think it is a helpful contribution."

      He said there was nothing to stop an independent Scotland using the pound outside a formal sterling zone in a move which would "liberate" the country from taking on a £125 billion share of the UK's national debt.

      My question remains. Are there any precedents for currency and debt sharing after a declaration of independence in advanced/European countries? For example, did Ireland take a share of the UK’s debt when it declared independence or did it just walk away? If anyone has any links on this I would be grateful.

    5. I think this link does as well as any I've seen to answer the question.

    6. @Jamie
      "In the negotiations around Irish departure from the UK in the 1920s, debt negotiation was a key issue. The parties started by making fairly maximalist demands as to what part of UK debt it would assume as equitable, the UK claiming a full proportionate allocation, and Ireland counter-claiming for a huge sum, including in-effect reparations for what it understood to be English wrecking of Irish industry from the point of Union in 1800.

      An agreement was reached which saw Ireland assuming some debt that would have been a significant burden to the Irish economy but was much less than the original UK position. But in fact – and here of course the politics of the time also played a role – it was ultimately made to pay – well a surprising £0.00."

  5. Anyway the overall picture is that electorally Salmon or what's his name is almost certain to be found out. He simply has no proper answers to serious questions that will be asked. Like EU membership before and now the currency. Next one probably: the border, Schengen.
    Or what to do if the UK leaves the EU? The guy is simply an incompetent twat that believes if things are said sufficient times they will happen.

    Hard to see how a majority could vote for something that might realistically mean: no EU membership for a few year; huge uncertainty about the currency and possible forced Euro membership and difficult border arrangements with the UK for both trade and travellers. The alternative with all its disadvantages looks a far better bet and a far more certain one.
    Plus the leadership as said simply looks crap and incompetent (no answers on important questions; no real solutions for real problems) and does everything to be found out considerably before the relevant vote/referendum.
    Campaigning for a cause for months, as he likely will do, that will be butchered in the ballotbox won't help either. Just make you look a bigger moron than you already are.

    Same with other things where it would be a surprise he had an appropriate answer on. Foreign service (probably relying in his conception on the UK); military (id). The guy simply hasnot got a clue what a seperate nation means. It means an own army, own CB, borders and that kind of stuff. And certainly not sherrypicking when it is not your call.

  6. It's an interesting situation; my personal view (assuming a 'yes' vote) would be for a temporary currency union until a Scottish Pound is created. I assume it would take a couple of years to establish a central bank and new currency during which reasonable fiscal policy would have to be implemented; however, the transition to a sub 3% deficit (my metric of a sensible deficit ceiling) would be difficult to achieve assuming deficit reduction stalls in 2013-14.
    However, all manners of macro aside, surely the glaring contradiction are the words "independent" and "EU membership"; you cannot be independent within the EU (Euro or no Euro). Given the profile of Scottish GDP (high net exports relative to rUK) an independent currency would be the most sensible option. This would require fiscal discipline with regards to oil revenue which is highly doubtful given all the talk of a "fairer" Scotland. Fairness is an idiosyncratic ideal and I doubt my definition of the word bares any resemblance to the government's.
    But, unless EU membership is ruled out or at least put to a referendum I will be voting unequivocally against.

    Great blog, totally unpoliticized.

  7. By the way, I am slogging through the Treasury document, and although it's a brilliant backgrounder, at 113 pages it is unlikely to achieve its goal of informing the voters. What will happen instead is that the voters will hear conflicting accounts of what the document says and what its motive are. Very few will actually read it, which is a pity because if they did, they would get a good view of what's wrong with the euro as a side-benefit.

  8. @jon
    They will get the message likely via the media:
    -no benefit in it for the UK.
    -and Scotland could be the next Spain if it increases debt too much or allows bubbles that subsequently burst.

    113 pages you always have to add a good summary. I would start with the summary and use the rest as annex/background material. As you say not many will read 113 pages (and boring stuff for most). And fewer will even start with it than when it is a 4,5,6 page summary (preferably less) with annexes.

    Typical weakness of especially economic papers. The summary is usually rubbish/highly unpractical. All the important info should be in the summary, but it hardly ever is. So you have to read the whole paper that hardly ever somebody does.

    Making it a bit of a pamflet imho is a bit doubtful, nothing hurts more than the simple truth presented in a businesslike way. And the basic message is hard enough by itself you donot have to spim it more.

  9. I think lots of people are missing the point, or making what philosophers call a 'category mistake'- the rest of the UK does not own the currency any more than it owns the embassies or the pension liabilities. All assets and liabilities are up for negotiation on independence. Otherwise, the rest of the UK (should it wish to unilaterally seize assets like the bank of england) must take all the liabilities as well, in which case Scotland will start with a clean slate and be debt-free. Obviously, any rational person knows that the former rather than the latter will prevail, which is why george osborne refused to rule out a currency union in his interview with gordon brewer, despite claiming it would be a terrible idea and those scots should know their place...

    1. I think you are making the mistake, this isn't anything to do with a category mistake - you have misunderstood what it means. Clearly if there is a continuing UK they can own the physical and non-physical assets of the UK, just as they do now. Only in the case where there are two successor states does the question arise as to who is the owner of the assets.
      The UK, as continuing state, will own the assets, then Scotland as a new state, will begin negotiations on what will be transfered, which will include assets and their liabilities. Debt free would be an option, but at the cost of being asset free.

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