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The Scottish currency question

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The Financial Times this week partnered with the Borders Book Festival, held at Sir Walter Scott’s home at Abbotsford, Scotland. It was a wonderful return to in-person events for me to join my colleagues Mure Dickie and Gavin Jackson there for a discussion on the Scottish currency question: what currency arrangement should a potential independent Scotland choose? (You should check out Gavin’s new book Money in One Lesson.)

Currency was one of the thorniest issues in the 2014 Scottish referendum debate, one to which many felt the pro-independence campaign had not given a good answer. If and when a new referendum takes place, this question will again loom large. Like the economy more broadly, the greater the perceived risk that something can go badly wrong with an independent Scotland’s monetary system, the more likely many people would opt to stay in the United Kingdom.

The prompt for our discussion was an essay by Sir John Kay, which cautions against moving away from the pound sterling. The challenges of a transition are, of course, enormous. There is no precedent for one part of an advanced economy to convert out of a larger currency in today’s deeply integrated cross-border financial system. (When EU countries adopted the euro, their national currencies were converted in their entirety. A Scottish secession would leave the pound sterling in place.) It would be hard to prevent citizens and companies from using sterling in private transactions if they wanted to. And the decision whether to convert existing assets and liabilities from sterling to a new currency — and if so, which ones — would inevitably leave some people short-changed.

My contribution to the discussion was to look at the Nordic countries that Scottish nationalists sometimes point to as examples of models for an independent Scotland. What is striking is that each offers a different package of EU association and currency regime. Norway is not in the EU but in the single market, and has its own floating currency. Sweden is an EU member with its own floating currency. Finland has joined the euro. And Denmark, an EU member, has opted out of the euro but has pegged its currency for nigh on 40 years, first to the German mark and then to the euro.

What does this show? I think three things.

First, that pretty much any currency arrangement is compatible with being a well-run, open, productive and socially cohesive economy. But that this also presupposes that the economies are actually well-run! The Nordics all display high political stability, responsible policymaking and solid public finances. When these are assured, a country can thrive with a range of currency regimes. Conversely, when they are lacking, every currency regime could run into problems. More important than the currency regime itself, therefore, would be an independent Scotland’s credible commitment to good economic management.

(Perhaps the Danish-style peg may be particularly vulnerable, as maintaining a fixed exchange rate is very hard in the face of capital flight. As it is, the Danish central bank has had to accommodate capital inflows in troubled times, which meant, among other things, becoming one of the first countries to introduce negative interest rates. But for most small economies, certainly for a newly independent and exposed one such as Scotland, the choice would really be between a floating currency of its own or joining a currency union with others.)

None of this alters the fact that getting to a possible new regime is fraught with challenges. If anything, it emphasises that getting to any of these destinations safely must be based on prioritising long-term economic policy and trusted public finances. There is no populist shortcut.

Second, if any of these currency regimes could work for a well-run economy, then joining a currency union, in particular, should be treated as a serious option. This has not always been the conventional wisdom in the UK (or the US) to put it mildly.

In the aftermath of the euro crisis, it was often said that a small country in trouble needed the freedom to devalue, with Ireland (in the euro) unfavourably compared with Iceland (floating currency) in the post-global financial crisis recovery. But a closer look at Iceland shows there is little to envy: its currency collapse, while drastically cutting Icelanders’ effective incomes, did not make their exports perform better than those of Ireland.

More generally, small economies stand to suffer a lot more from exchange rate volatility than they gain from a supposed monetary independence that in a financially integrated world is largely illusory. (I have argued even the UK could have gained from joining the euro.)

That leaves the question of whether the right currency union for an independent Scotland would be with sterling or the euro. At least we can say — this is my second reflection — that a formal currency union is surely better than informally using another country’s currency. Part of the currency choice would, therefore, depend on the prospects for a formal sterling union and those of EU membership. I, for one, find it hard to imagine that a newly independent Scotland would be granted a greater formal say on the monetary policy of the Bank of England than it has as part of the UK.

My third reflection is that the choice between sterling and the euro really depends on a bigger choice about the economic orientation of an independent Scotland. Should it seek to retain tight economic relations with the rest of the UK, or allow those relations to suffer for the sake of closer economic relations with the EU? The UK’s hard Brexit, unfortunately, has made that a starker choice.

The answer would be for the people of an independent Scotland to decide, of course. But it seems to me that a choice for independence would be motivated in part by a desire for a different orientation of economic (and other) links. If so, then a referendum that took Scotland out of the UK would put it on a path that ends with the euro.

Other readables

  • Newly published research on the eurozone economy suggests loose monetary policy does not undermine fiscal responsibility, contrary to what some monetary hawks claim. If anything, fiscal policy becomes more sustainable after a monetary loosening.

  • The debate on what it is to be European, which Free Lunch contributed to earlier this year, rumbles on. In a discussion with Pierre Manent, moderated by Le Grand Continent, Luuk van Middelaar calls for the construction of a narrative of European identity. The problems with such a call are highlighted by Hans Kundnani, who started the original debate by pointing to the nationalist and racist undertones of pro-Europeanism.

  • Raghuram Rajan offers one of the best policies to combine incentives to decarbonise with financial aid for poor countries to do so: create a global fund that you pay into if you emit more than the global average per capita, and get money out from if you emit less.

  • Daniel Gros and Farzaneh Shamsfakhr of CEPS contribute to the inflation debate by examining two-year annualised core inflation — they looked at energy price volatility and “base effects” related to big price changes in the depth of the pandemic. They found a transatlantic divide: eurozone inflation is well contained below 2 per cent, but US inflation is not.

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