Following the last post on currency I got embroiled in a couple of discussions on the topic on social media which made me realise that knowledge on the topic is not particularly good. This includes some politicians who don’t seem to understand the difference between money (an asset) and currency (a means of exchange) – declarations that “the pound belongs to us all” only display their ignorance.
Below we list the main options that an independent Scotland might reasonably consider. Essentially these fall into 3 main groups – keep the pound, create an independent currency and join the Euro. However within each of those there are further options within these groups which are material and we see six different combinations to consider. We’ll also note that we may see more than one of these as some may appear as transitory arrangements. I should also say that while I have tried to be as objective as I can in the discussion, I do have a very strong view on independence which may be influencing my commentary.
1(a) Keeping the Pound (1) – Monetary Union
Clearly has many advantages for the SNP in the referendum – the Scottish population is largely attached to the pound and the prospect of losing it would lose them lots of votes come September. This is clearly good for continuity and would be the preferred option for businesses. It would also probably give the lowest interest rates outside joining the Euro.
There is are some buts however. The SNP’s preferred power share is a clearly non-starter with UK politicians for understandable reasons – they have drawn the line consistently with Europe, staying outside the Euro. This means if there was a monetary union it would be completely under residual UK (rUK) control.
Not only would governance of monetary policy would then reside inside foreign power, but any agreement with rUK is very likely to impose restrictions on fiscal policy. These could be so strong that some may question how independent Scotland really is – indeed many believe the logical end of monetary union is political union.
The biggest but of all is that this isn’t really good for rUK. They have to cope with the political difficulties that running policy for a country that has no representation creates, but they are also potentially on the hook should Scotland get into fiscal difficulties. This could come from government policy (heavy debt funded spending or tax base collapsing) or financial institution collapse (the much quoted bank position.) Either way, it is clearly better for rUK to be shot of those risks and that is what they have chosen to do.
How good for Scotland? 8/10
How likely? 0/10. Despite the SNPs attempts to keep this option alive, it is clearly dead in the water.
1(b) Keep the Pound (2) – Sterlingise
If Scotland is desperate to keep the Pound as its currency then it could do so outside a monetary union. The transition could be painful, as the withdrawal of Scottish banknotes could create a very deflationary environment in the short term. The effect on rUK would be much smaller, but still noticeable, so there may be a boost to the money supply by the Bank of England to compensate. If planned for by all sides the actual disruption may be slight, unless deflationary expectations become embedded and Scottish asset prices crash.
In the long run, of course, that would pass and a more normal environment would return. However Scotland would have no influence over monetary policy at all. A lender of last resort would still have to be created in Scotland to keep the banking system stable, and the scale of the potential liabilities may create difficult questions unless there is a large (relative to GDP) pool of assets availability. In other words Scotland would have to create most of the institutions required for an independent currency anyway. Given all that interest rates are likely to be significantly higher than under option 1(a), especially in the short run.
How good for Scotland? 2/10 (short term) 5/10 (long term)
How likely? 1/10 Although the SNP appear to be stumbling towards this, even before Mark Carney’s comments it was difficult to believe it was a serious option.
Welcome the McPound
We now consider the options under a new Scottish currency. Personally, I like the name McPound (Mc£) for it. Although don’t want a well known burger chain suing:)
All these have some things in common – creation of a Scottish Central Bank, the need for currency reserves, solid financial company regulation and lender of last resort. All are achievable, though the cost may vary significantly depending on the circumstances and there is an inevitable transition risk.
2(a) New currency (1) – Link to the Pound
The most obvious alternative in the current circumstances is for the new state to create an new currency and immediately peg it so that Mc£1 = £1. This has some intuitively obvious advantages – clarity for business and trade and ability to keep existing banknotes in circulation. The transition could be done pretty smoothly.
There are several disadvantages. The big one is that to keep the exchange rate guarantee in place the new country would have to find some very large currency reserves – certainly much larger than what it would get as a fair share of the UK’s reserves. Without that the currency markets would worry that the peg is unsustainable. Monetary policy would have to have maintaining the peg as its primary objective, which at times will mean very high interest rates and difficulty in controlling inflation.
The second is that the peg may not be seen as permanent by the currency markets (most break eventually) and they will demand higher interest rates accordingly. Breaks could be provoked either up or down and would likely lead to substantial exchange rate moves. If Scotland is, in essence keeping its currency down (perhaps, for example, due to a spiralling oil price) then the sharp move upwards on a break would hit exporters hard, probably provoking a deep recession. If on the downside it suggests the Scottish economy is already struggling and removing the link may actually be helpful in restoring competitiveness. Unfortunately the appeal of this is another reason for markets demanding higher interest rates to protect them from a potential devaluation.
How good for Scotland? 3/10
How likely? 2/10 – only as a transitional arrangement.
2(b) New currency (2) – Floating Pound band
Similar to 2(a), but instead of fixing the exchange rate the new government sets a policy of maintaining the exchange rate in within a range of, say, ±10%. i.e. between £0.90 and £1.10. This is well known within currency markets, albeit in the UK with scorn for when it jumped in and out of the European exchange rate mechanism (ERM) in the early 1990s.
This has significant advantages over the previous option. By having greater scope for the currency to move it gives more scope for monetary policy to focus on domestic conditions. So probably lower interest rates and inflation. Certainly they would be less volatile. Secondly breaking the band will have less dramatic consequences, giving a lower risk premium. The need for the new country to establish market credibility is less and so it could get away with smaller currency reserves, albeit probably still larger than its initial UK allocation.
Having said that the same disadvantages remain as before, just the severity of the risks is lower. To this there is the disadvantage for trade of currency uncertainty, frictional and possible hedging costs. In the overall mix these are relatively small, but permanent.
How good for Scotland? 5/10
How likely? 4/10 – still flawed, but perhaps offers enough compromises to keep everyone happy.
2(c) New currency (3) – float it!
The third option for the new currency is just to ignore its value relative to the Pound and let it float freely. This diminishes the risks of the above two options – there can be no consequences from breaking bands that don’t exist. The need for currency reserves would be even smaller again, and possibly the natural share of the UK’s may be enough.
The disadvantages are two fold. Firstly the hassle for business could be more than before, particularly if the new currency proves to be volatile (not unknown amongst pert currencies.) Secondly, particularly in the short term, interest rates are likely to be higher (Citigroup estimate 1-1.25% higher). While there is not the need for instant financial market credibility that the preceding two options require, it may still be something that takes a while to appear with a direct financial cost in the interim.
How good for Scotland? 5/10
How likely? 6/10 – it is where the three preceding options probably lead to in time.
3. Join the Euro
Assuming that the club allows it to join – and currently Scotland would not meet the criteria – the final option is for Scotland to join the Euro. Actually it remains an open question as to whether Scotland may be forced to set itself on this path as a price for joining the EU, in which case this discussion is somewhat moot. In theory this would require a transitional period of at least two years during which Scotland would have its own currency. Though this is a potential hassle in the short term it may bring advantages too e.g. if the ECB can act as a lender of last resort Scotland gets instant financial credibility.
The flaws of the Euro are well known – its ‘one-size-fits-all’ monetary policy and the difficulties of coordinating its members for example. The former may be significant given Scotland’s economic cycle is more aligned with the UK than Europe. But the Euro zone does seem to have weathered the crisis and looks better than it did only 12 months ago. Although Germany has the most influence, the governance is set up to include all its members. The fiscal and monetary conditions are well known, not hugely restrictive and there is a precedent for relaxing them as required (the latter has both good and bad aspects).
For Scottish business the Euro area is its second largest export market, so a common currency would offset some of the new costs of dealing with rUK. Perhaps most appealingly, interest rates may be lower than any other option, including monetary union with rUK. If it wasn’t for the transition risks this actually may have outscored option 1(a).
How good for Scotland? 7/10
How likely? 1/10 – despite the economic advantages it is a political non-starter.
This list is not exclusive, either in terms of options (peg to the US dollar anyone?) or advantages/disadvantages. There are other factors which would influence the attractiveness of each option too e.g. if Scotland renounces its share of UK debt or financial institutions all flee to rUK then some things change significantly.
The scores are, of course, entirely subjective but I hope will give some thought when it comes to discussion. Even the mighty S&P seem to think Scotland would be better off in a monetary union, and if one with sterling is out then the Euro should be seriously considered. What’s your thoughts?
19/3/14 – edited to correct reference to McDonalds