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Scotland’s currency paradox

February 15, 2012

My piece in today’s Scotsman:

SHOULD Scotland win independence, the question of currency must be addressed, but keeping the pound would be in the country’s best interests, writes Daniel Gay

Ditching the pound would narrow Scotland’s economic options, not enlarge them. Even if Holyrood keeps sterling, the eurozone crisis shows that independence risks throwing away some hard-won freedoms.

A healthy currency is a golden prize, as Europe is discovering. In a classic 1961 article Nobel prize-winner Robert Mundell theorised that a currency zone was only optimal if capital and labour could flow easily from one area to another. A bit like the way that pouring water into one corner of an ice cube tray fills the other sections evenly, workers and capital would move to fill in any economic gaps. Mundell argued that to make up for remaining unevenness and differences in economic cycles, a central authority would need the mandate to tax the prosperous parts and spend more on the laggards.

Half a century later the Eurocrats would do well to reread Mundell’s paper. Optimal the eurozone is not: the result of naïve optimism and bad design.

Capital didn’t flit in a jiffy from Paris to Lisbon. How many Slovakians flew to Austria to find work, or Greeks to Belgium? Internal migration remains low because people are comfortable with their own cultures and languages.

Another design flaw is that no central agency has control over spending. When France and Germany broke the 3 per cent budget deficit target in 2003 Brussels could only watch. Contrary to prejudices about southern fecklessness, Franco-German rectitude is a myth.

A paper by Charles Wyplosz of the Graduate Institute in Geneva found that France flouted the rules in seven of the 12 years after the euro began and Germany five. Every country misbehaved, because nobody could punish them.

Compounding the difficulties, a single interest rate set in Brussels (by an inflation-paranoid European Central Bank) doesn’t fit all 17 members. The economic result: more black spots than an adolescent Dalmatian.

The United States is almost the perfect currency zone. Workers and capital move freely between states, helping equalise differences in wages, employment and financial returns.

Few barriers to investment exist between states; most people speak the same language (English, not Spanish); and cultural differences are minimal. At the drop of a Stetson, a Texan will relocate to New York to get a better job.

US states control their own budgets, so they can fine-tune spending. The 12 Federal Reserve banks each have a role in deciding interest rates. And even if the internal movement of capital and labour doesn’t smooth out economic differences, the Federal government can step in to bail out flagging states or issue a rap on the knuckles when a governor gets his wallet out once too often. These reasons are partly why the American economic recovery is outpacing Europe’s.

The UK currency area has outlasted any other. In 1603 the pound Scots was pegged to sterling at a rate of 12 to one. In 1707 under the new Parliament of Great Britain, sterling replaced the pound Scots as the legal currency.

Just like the dollar, the sterling area has all the right ingredients: Brits speak the same language; capital and workers can move easily from one area to another; the central bank sets an effective monetary policy for the whole country; and the government can spend more in one region when growth falters.

As Alex Salmond seems to be acknowledging, the euro’s toxicity burnishes the allure of the pound.

But a new article in the National Institute Economic Review by Angus Armstrong argues that: “It is noteworthy that at the same time that Scotland may [give up fiscal union], the Euro Area countries are looking… precisely to secure the fiscal union that Scotland may leave behind.”

Under the sterling zone, Westminster and Edinburgh share revenues and debts. Armstrong calculates that in the event of a split Scotland’s public debt would total about three-quarters of Gross Domestic Product depending on how oil revenues are shared.

The deficit – how much more the government spends than earns – would have been about 4 per cent of GDP over the past half-decade assuming Scots got their geographic share of oil.

That’s not too bad in today’s climate, but a hefty sum of investment comes from abroad. Despite Donald Trump’s grumbling, all those renewables projects from down South create a lot of jobs.

Firms based elsewhere in the UK account for a fifth of employment and turnover and almost half of registered medium and large companies, according to the Office for National Statistics. Companies from the rest of the world provide 16 per cent of employment and 36 per cent of turnover.

One of the big lessons from the euro crisis is that small countries relying on foreign investment must pay more to borrow.

Using the pound and issuing government debt in sterling, Scotland would lose the ultimate response of printing money to repay creditors. This risk would further hike interest rates on government debt.

As the Italians, Greeks, Spanish and Irish know only too well, being bullied by the bond markets is a harsh form of discipline; the kind of discipline that means less cash for schools and hospitals.

The Bank of England wouldn’t want to play central banker for Edinburgh without guarantees on Scottish spending, because otherwise it would effectively be writing blank cheques. Any Holyrood backstop would cost yet more money.

Having unravelled the union, Scotland would have even less control over official interest rates than it does now. The British central bank doesn’t currently pay much heed to events north of the Border, but in future it wouldn’t even have to bother pretending. An English boom at the same time as a Scottish slump could prove disastrous.

Scotland could cut out the Bank of England by issuing its own new legal tender. Jim Sillars has argued for a Scots dollar and the SNP is said to be keeping the option as a back-up.

But setting up a currency isn’t like opening a new Paypal account. Edinburgh would need its own central bank equipped with an arsenal of foreign exchange sufficient to fight off speculators – who would be queuing up to test the fortitude of a newly-minted currency in a resource-rich country.

Some small Asian countries learnt from their regional own economic crises in the late 1990s that they would need reserves of up to twice GDP. In Scotland, not all of the necessary scores of billions of pounds could be coaxed from the coffers of Threadneedle Street.

To have any credibility the Scots unit would need to be pegged to the pound, a move which would constrain monetary and fiscal policy.

And the credit ratings agencies have in recent months hinted that Holyrood’s debt would receive a lower rating than the triple-A currently enjoyed by the UK. That could raise interest rates to more than double those currently paid by the British government, according to some estimates, and they would be even higher with a new currency than if Scotland broke with England but kept the quid.

Many of the 126 nations with smaller populations than Scotland will testify that control over education, health and defence can reap bigger rewards than the economic gains from staying glued to a union.

But even if Scotland sticks with sterling, in splitting with its neighbour it might abandon exactly what Europe covets. Freedom often comes in a strange guise.


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