Which will be best currency for an independent Scotland?

Readers question: Would Independent Scotland be better with the Pound, Euro or an independent currency? What are the risks for each scenario?

Scotland using the Euro

If Scotland use the Euro there will be some benefits from having a shared currency with the rest of the Eurozone.

  1. Scottish business and personal users will have lower transaction costs when travelling to Europe.
  2. Having the Euro could possibly encouraged foreign investment from European firms wishing to invest in a part of the British Isles now using the Euro.

However, these benefits of the Euro are significantly diminished by the new additional transaction costs of exchanging currency with the rest of the UK. Cross border trade with England is likely to dwarf the number of Scottish people travelling to the continent.

Also, given the ease with which business can convert currency and hedge against currency movements, I don’t feel that the UK has been at a significant disadvantage to retaining the Pound.

A much bigger issue for Scotland using the Euro is the very real concern that Scotland could face similar problems to other peripheral countries. What are the risks of Scotland using the Euro?

  • Scotland will have monetary policy set by the European Central Bank. You could argue the Bank of England don’t always set interest rates according to the interests of the Scottish economy. But, there is likely to be a greater divergence between Scotland and the rest of the Eurozone. If Scotland join the Euro and experience ECB interest rates (set for 16 countries), Scotland could face high interest rates when in recession or low interest rates when the economy is picking up with inflationary pressure.
  • Bond market. In the recent recession, the Bank of England has been active in buying government bonds. This has provided sufficient liquidity in the bond market. The consequence is that bond yields on UK debt have fallen to near record lows. By contrast, countries in the Eurozone have suffered from periods of very high interest rates. Markets fear the liquidity of Eurozone countries because the ECB has not always been willing to act as lender of last resort.
  • Note: Some countries have seen rapidly rising interest rates with reasonably low levels of government debt. Bonds spiked in Spain and Portugal, despite government debt as a % of GDP being relatively low at the time.
  • To some extent the ECB has overcome this issue by its greater willingness to intervene in the bond market. But, there is no guarantee the ECB will always have the willingness and ability to decisively intervene in the bond market.

There is a real concern that if Scotland adopts the Euro it will face two potentially very damaging problems

  1. Higher bond yields, increasing cost of debt payments.
  2. Greater pressure for austerity. Euro members have faced much greater pressure to cut government spending and balance the budget. The problem is that this pressure to pursue austerity in a recession has been economically very damaging. It has cause much higher rates of unemployment across Europe than compared to the UK.
  • Trade imbalances. Another feature of the Euro is that peripheral countries have often found themselves becoming uncompetitive within the Eurozone. For example, Spain and Greece saw rising wage rates and higher costs push inflation. But, because they cannot devalue in the Euro, they just became uncompetitive. This led to record current account deficits and lower economic growth. The process of internal devaluation to restore competitiveness has led to many years of low growth and high unemployment.

Scotland sticking with the Pound

If Scotland stick with the Pound Sterling it would make the most economic sense. It would avoid any transaction costs and uncertainty of changing currency. It would also avoid the potentially damaging costs associated with joining a single currency.

It would mean monetary policy would still be set by London by the Bank of England. This is a potential downside if the Scottish economic cycle becomes divorced from the rest of the UK. But, I don’t think the single currency and single monetary policy for the UK has been particularly damaging to the Scottish economy. The Scottish and English economies would count as an optimal currency area. Geographical mobility is good between England and Scotland, and there is a strong correlation of the economic cycle.

Scotland with own currency

If Scotland had its own currency it would create significant transaction costs for cross England Scotland trade.

It would also raise problem of fluctuating exchange rates between Scotland and England which may discourage cross border trade.

The potential advantage is that Scotland could have its own monetary policy. It wouldn’t have to be concerned about a housing bubble in the south of England. If the Scottish economy was depressed, it could cut interest rates to boost economic activity in Scotland.

It is true Scotland has had periods of higher unemployment than other parts of England (also there has been higher unemployment in the north of England compared to the south). There may be a case for a different monetary policy for Scotland. But, this unemployment has been often been structural factors as much as a widely divergent economic cycle. I don’t think the fact monetary policy is set in London has been a major stumbling block for the Scottish economy. Though you could argue there are potential advantages to setting an independent Scottish monetary policy.

Some may argue a small economy like Scotland may be more vulnerable to exchange rate fluctuations and a loss of confidence in the currency. But, I don’t think size of the economy is a major factor. If Scotland has major oil reserves this could lead to a significant appreciation – which is good for consumers buying imports, but bad for exporters losing competitiveness.

Conclusion

There are few benefits for an independent Scotland switching away from using the Pound Sterling. Adopting the Euro could be devastating and could lead to years of self-defeating austerity and stagnation. No one joining the Euro anticipated it would be so bad for their economy, but the Euro has definitely been a major factor in causing the worst recession and period of unemployment since the 1930s. There is no economic logic to risking going down that option.

An independent Scottish currency would be less damaging than the Euro. But, the benefits fairly limited and it would create needless friction in cross border transactions. The best option seems to be to stick with the Pound Sterling.

 

 

By on January 23rd, 2014

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