Scottish independence: does taking a sterling currency union off the table change the game?

The heavy trailing of an announcement by the Chancellor of the Exchequer (and Danny Alexander and Ed Balls) that the UK Government is not prepared to establish a currency union with Scotland for use of the pound in the event of Scottish independence (see also BBC News coverage here) is a serious blow to aspirations of the SNP for a form of ‘independence lite’.  The logic of this was that it would avoid disrupting many key symbolic and economic ties between an independent Scotland (iScotland) and the remainder of the UK (rUK), so comforting swing voters about the limited scale of the risks of independence.  Those risks are real; think of how attractive Scottish investment trusts and insurance companies look if the complexities and exchange-rate risks of using a different currency are introduced into the equation, for example.  But this shift in the ground also emphasises a number of key issues about the implications of a Yes vote, and what would happen after it.

The first problem – which is particularly the case with the idea of a currency union, but applies to many other important issues – is the asymmetry of interest.  A currency union is central to the way the SNP has formulated its model for independence.  (That view can be contested, of course – whether by the likes of Jim Sillars on, essentially, autonomy grounds, or by Angus Armstrong and Monique Ebell on economic ones, relating to the flexibility of economic policy instruments and the implications of a debt burden.)  But it is of marginal interest or benefit to rUK at best, poses a serious risk at worst, and concluding that the risks of it from an rUK point of view exceed the benefits is a reasonable judgement to come to.  This isn’t the only issue where iScotland has a strong interest in something of limited concern to rUK, either.  In bargaining situations, iScotland has got to have something convincing to offer to rUK – and other than staying in the UK, or the Clyde nuclear bases, it’s hard to see what that might be.

The second problem is what the Yes side do in response to being denied a currency union – the ‘Plan B’ for iScotland’s currency.  There aren’t many currency options; they are using the pound without a currency union (‘dollarisation’ or perhaps ‘sterlingisation’), establishing a Scottish currency, or seeking to join the Euro.  (The clearest exposition of those is in a video put together by NIESR, available here.)  The first and third of those pose major problems – dollarisation/sterlingisation would be unstable and expose iScotland to a range of monetary policy risks over which it had no control, while membership of the Euro normally requires having a national currency first, and then joining the Exchange Rate Mechanism to start the process of tying that currency to the Euro.  That implies a lengthy transition, a currency that sunders Scotland from what at the moment is its closest trading partner, and the question of what the constraints of the Eurozone might be in future.  From that point of view, an independent currency is the least unattractive option by some way – even if it seems riskiest to referendum voters, and proposing it now would indicate a significant reshaping of plans for independence at a late stage in the referendum campaign.

The third problem is how rejection of a currency union affects other options for ScotlandTalk of repudiating iScotland’s share of UK debt may be attractive to SNP politicians, but is hot-headed nonsense.  It would create the very opposite of the ‘velvet divorce’ which underpins the Yes side’s strategy.  Indeed, it would amount to a unilateral declaration of independence, as well as creating a major ongoing dispute with rUK.  That would affect all plans for independence, not just currency; social union, an open border, co-operation in other matters will all be off the table.  It would create significant obstacles to any negotiations over EU membership, and an insuperable barrier to NATO membership, and make it very expensive for iScotland to borrow from international lenders if it could do so at all.  Reaching a deal on at least the main issues that underpin statehood with rUK would be vital for Scotland to become independent, and the asymmetry of interest means that rUK holds the whip hand in each strand of those negotiations.

The fourth problem is what this means for ‘independence lite’ as a wider project.  The idea that independence would widen the realm of autonomy in some areas (such as fiscal and social policy, and to some degree foreign policy) while retaining existing aspects of the Union such as currency or freedom of movement across the England-Scotland border may be attractive in Scotland.  But the reliance on rUK co-operation and goodwill has never made it a robust and achievable plan for independence, and that is what is starting to unravel for the Yes side.  Moreover, they are hoist to their own petard in two ways.  They have wanted to clarify the basis for independence before September’s poll; while the UK Government has rejected ‘pre-negotiation’ of independence, on currency it is clarifying its position in perhaps the most unhelpful way possible.  The Yes side also has (perhaps reluctantly) embraced the binary Yes/No approach to the referendum (and lost the possible ‘third option’ from the poll).  ‘Independence lite’ was a way of softening the impact of the choice of independence for swing voters and reinstating to a degree the middle ground that was otherwise excluded.  But the rejection of a currency union deprives the Yes side of that comfort as well.  As a result, the choice between independence and remaining part of the UK is becoming increasingly stark.

The challenge that now faces the SNP and the wider Yes campaign is whether to embrace a more radical approach to independence, which may be less attractive to key groups of swing voters (though not other parts of the Yes movement), but produce a more intellectually cogent model of independence, or stick to a middle course predicated on agreements with rUK that look increasingly hard to attain.  Nicola Sturgeon’s diary for the next few weeks includes lectures at UCL (this Thursday) and Cardiff on 24 March, so she will have plenty of opportunity to answer such questions.

None of this alters certain key facts, though.  The Scottish public still support an expanded form of devolution – not independence, but something that confers signficantly greater autonomy than the status quo.  Formulating that option is something that the Unionist parties need to do.  It is in their interests to make devolution work better, after all, as well as enable Scots to have the form of government they desire.  And putting such an option on the table will help people to regard voting No as a positive choice, not just a reaction to the uncertainties surrounding independence.  That also appears to be what voters want, and it is certainly necessary if the referendum is to resolve the wider question of Scotland’s place in the United Kingdom, rather that invite a ’round 2′ of the independence argument at some later date.

UPDATE, 13 February: There are also interesting comments on the currency announcement from Angus Armstrong of NIESR here, Alex Massie for the Spectator Coffee House blog here, and from the Guardian David Torrance in Comment is Free here and Larry Elliott’s Economics Blog here

Further update: The Chancellor’s speech is now available here.  The key points are his linkage of a banking union (necessary to support a shared currency) with a wider fiscal and political union, the question of what benefit rUK would derive from such a union given the asymmetry of the risks, and how stable and durable such a union would be – the possibility of one party choosing to break it.  To quote one passage:

The continuing UK would be almost ten times the size of the Scottish economy. So this would be a totally one-sided deal where UK taxpayers would have to transfer money to an independent Scotland in times of economic stress, with limited prospect of any transfers the other way.

We got Britain out of the eurozone bailouts. Now we’d be getting into an arrangement that was just the same.

The citizens of the rest of the UK could not sign up to such a deal. And frankly, even if we could, I do not think Scotland would want to either.

For the logic of a currency union would mean that Scotland would have to give up sovereignty over spending and tax decisions.

And another:

Because sharing the pound is not in the interests of either the people of Scotland or the rest of the UK.

The people of the rest of the UK wouldn’t accept it

and Parliament wouldn’t pass it.

The Treasury analysis – the eleventh paper in the ‘Scotland Analysis’ series – on which Osborne drew in his speech is available here.

This post now also appears on the UK Constitutional Law Association blog, here, and the Constitution Unit’s blog, here

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Filed under Scotland, Scottish independence, SNP

4 responses to “Scottish independence: does taking a sterling currency union off the table change the game?

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  4. Jean du Pays

    Monetary Union “Bait and Switch”:
    The politics of post-secession monetary arrangements

    A lot has been written recently about the likelihood (or unlikelihood) of Scotland being able to use sterling were it to become independent. (And indeed, we’ve heard similar debates in the past — and are starting to hear renewed stirrings of such debates — on this side of the pond here in Canada as well.)

    A lot of the analysis has focused on the economics of monetary unions and “optimal currency areas”: the credibility of the Scottish case (and possible lack of credibility of the Unionist one in Scots’ ears) largely rests on the simple observation that with economies that are already strongly integrated (and inevitably so for simple reasons of geography), it just makes sense – i.e. it would be in the interests on both sides – to continue with what’s already there.

    This is obviously reassuring for those Scots who might be wary of what Alex Salmond might be up to if he were to admit he was actively looking at setting up a separate Scottish currency. If worse comes to worst, I expect that the SNP and its allies will simply assert that they could and would continue to use sterling even outside a formal monetary union (i.e. some sort of “sterlingisation”): this would further reassure Scots that even if the unionists weren’t bluffing about refusing them a formal monetary union, something not terribly dissimilar to it (in daily life) would still be a live option – given that it would be very difficult (and harmful to its own economic interests) for the rUK to prevent Scots from making informal use of sterling.

    Now, I don’t want to downplay the real issues associated with an informal monetary union : the lender-or-last-resort problem and associated financial sector regulatory challenges – especially given how big that sector is in Scotland; the need to accumulate large sterling reserves to back up the kind of currency board arrangement that would maximize the credibility of its informal use of sterling; the complications of Scotland acquiring market credit-worthiness outside the familiar sterling monetary arrangement, and so on. The papers prepared and published by the UK government thus far do a very good job of describing these issues in an economically competent (but still fairly readable) manner.

    There’s something missing, however, in the “calculus of interests” that’s been done thus far. It relates to what the political interests of the Scots (and of the Scottish government in particular) would be in relation to monetary arrangements in the wake of the inevitable economic and fiscal disruptions that secession would entail – and of the potentially significant doubts that markets in particular might entertain in relation to the credibility of the Scottish commitment to sterling.

    A lot of the now all-too-familiar concerns raised about even formal monetary unions that are divorced from fiscal unions such as the eurozone is that there aren’t many mechanisms left for adjustment to the impacts of asymmetric shocks to different parts of the monetary union. If you can’t devalue your exchange rate relative to other members of the union, can’t pool risks with them through the “insurance policy” of fiscal transfers, and can’t be sure of being able to wait out the shocks through deficit-financed benefits and subsidies (e.g., if, like Scotland, you don’t really have a track record as even a sub-sovereign borrower), you’re basically stuck with having to adjust through wage and price adjustments.

    Now, the politics of such adjustment is quite asymmetric: if a shock is a “favourable” one, wages and prices (including asset prices giving rise to capital gains) basically just rise, leaving (most) people better off. But if a shock is an “adverse” one, that means wages and prices may well need to fall. Given that wages in particular are “sticky”, the upshot can be a significant rise in unemployment and widespread misery: witness southern Europe. Needless to say, governments tend to have an easier time with the former kind of shock than with the latter.

    In practice, secessions themselves are almost invariably asymmetric and result in asymmetric fiscal shocks across the divorcing units. Typically, it’s a small unit that secedes, leaving a bigger chunk behind as the successor state. At the very least, the seceding unit starts life facing a significantly higher cost of funds than its fellow divorcee. Though both of them may face a higher cost of funds, it’s the smaller and less familiar of the two that’s likely to see by far the bigger increase. So, even with existing pre-secession debt amicably and fairly divided between the two units (approximately in proportion to GDP or population, say), it can translate into a quite asymmetric fiscal “hit” – especially where the debt is a large proportion of GDP to begin with.

    Seceding units also have new expenses to cover. In particular, things that were formerly done centrally (e.g. national defence, missions abroad, the mechanics of taxation, debt financing and program service delivery) now have to be duplicated, with a loss of economies of scale that is borne disproportionately by the new, smaller unit. (The larger remaining unit may even see minor reductions in its variable costs of administration, though these gains would be small relative to the increase in fixed costs that would need to be borne by the smaller unit.)

    In cases where the smaller seceding unit had formerly been a “needier” part of the union (i.e. its residents received, or were projected to receive, a disproportionately large share of government transfers and other spending and/or their lower incomes and asset values translated into a disproportionately small contribution to government revenues), it would face additional fiscal shocks associated with the expectation that it would at least maintain pre-secession levels of public services and not increase the tax burden on its residents.

    Given how important capital flows have been as a cause of economic shocks in the last decade, it’s also important to note that post-secession capital flight (even if only to fully safeguard assets currently denominated in the common currency) is also likely to be significantly asymmetric – and here too, this is more likely to adversely affect the smaller unit more than the larger one. In the particular case of Scotland’s (disproportionately large) financial sector, outflows of deposits and other sources of finance for financial institutions could well translate into some sort of significant credit crunch, and perhaps renewed liquidity or solvency concerns that a newly independent Scotland might be ill-equipped to backstop.

    The asymmetry of such impacts across divorcing members of a former union suggest that the need for the smaller unit to call upon a range of adjustment mechanisms – including exchange rate devaluation – will tend to be greater than those of the larger unit. Since this difference in need could not be accommodated within a formal (or informal) monetary union, secession would tend to translate into much more politically painful adjustments – e.g. though wages and prices – to adverse fiscal shocks in the smaller unit and to much less painful adjustments (and maybe even minor politically beneficial adjustments to “favourable” net shocks) in the larger unit.

    Under these circumstances, markets could be excused for doubting the short- and longer-term commitment of an independent Scotland to use of sterling, setting into play the familiar cycle of rising cost of funds and/or drying up of lending, leading to a fiscal crisis that could ultimately be escaped through a reset of the exchange rate though adoption of a separate currency.

    More to the point here, however, is that there would be a particularly strong political interest on the part of newly independent Scottish authorities to pre-empt such a politically damaging scenario (“independence as growing fiscal and economic nightmare”, instead of the promised sovereign nirvana) and to move immediately to the adoption of a separate (and heavily devalued) currency notwithstanding that they may have previously campaigned on retention of sterling. What makes this a potentially feasible – and politically defensible – manoeuvre (notwithstanding that it would effectively involve rewriting most/all Scottish wage and price contracts to substitute debased coin for sterling) is the possibility of deflecting the blame for incipient financial and monetary chaos clearly at the feet of the “lack of good faith” or even “ill will” of the leadership of the rUK toward the newly independent Scotland (or at least of doing so credibly in the eyes of the Scottish electorate).

    The window of opportunity for effecting such a manoeuvre would be a narrow one: in the immediate aftermath of achieving independence when recriminations over “unfair terms” and “negotiating in bad faith” might most easily be harnessed. (Recall that the post-Velvet Revolution monetary union between Slovakia and the Czech Republic lasted barely a month.)

    Moreover, for political asymmetry reasons as well, there would be a clear interest on the part of a newly independent Scotland to engineer a particularly sharp devaluation – i.e. an “overshoot” relative to what would likely be the market-determined exchange rate under an eventual return to “new normal” conditions. If the initial exchange rate of the new currency proved inadequate to offset the adverse fiscal and economic shocks of secession, further devaluations (and corresponding reductions in Scots’ living standards) would be required – further undermining public confidence in the political leadership’s management of the country’s affairs. By contrast, an overshoot would lay the groundwork for a highly competitive Scottish economy that could expect to maintain high employment, accumulate significant foreign exchange reserves and see a long period of post-devaluation increases in wages and prices – for which the Scottish government could be expected to take credit, citing its “sound management”.

    In short, the SNP’s optimal political strategy in relation to monetary union may well be a variant of the time-honoured “bait-and-switch” marketing trick: reassurances today that Scots can keep sterling (one way or another), then blame the English tomorrow for making it impossible to do so (even though it was in the marketers’ interests all along to get them to that point).

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