What would those currency options be?
An independent Scotland would essentially have two viable currency choices: continued use of UK£ within an informal currency union or the establishment of a new currency (a S£) whose value would be market determined.
The experience of the 2014 referendum has all but removed the option of a formal Sterling currency union. The Euro – an alternative formal currency union – is a possibility but involves a set of conditions an independent Scotland would be highly unlikely to meet in the short term, even if doing so became a policy priority. Maintaining a fixed value of a Scottish pound (S£) against any other currency would not be possible without large foreign exchange reserves.
The latest economic proposals from the Scottish government envisage the use of the UK£ after independence, followed by the transition to a new currency ‘as soon as practicable’. In the press conference accompanying the proposals, the First Minister was careful to avoid any timetable but pushed back at a questioner talking of ‘a decade or more’.
The proposal lists requirements and criteria that would need to be met before the adoption of S£. These bear close comparison with Gordon Brown’s tests for joining the euro when he was UK Chancellor of the Exchequer, albeit in this case the tests are designed to lead to a yes rather than no answer. The requirements and criteria are nearly all already decided in the context of transition ‘as soon as practicable’ or would need to be in place before independence.
In particular, Scotland would need credible institutions at independence and a clear plan for the transition to a new currency. Without those, reasonable-cost Scottish government bond market borrowing will, at best, be limited to the short term so that repayment is well in advance of the transition, or not be achievable at all. Even with the responsible fiscal policy a newly independent Scotland would need, the cost of government borrowing will be central to economic success.
The advantages of delaying the move to a S£, therefore, come down to providing more time to prepare for a new currency and establish a track record and reputation for responsible economic governance. We should not underestimate the overall challenge of preparing for all aspects of independence, so delaying some of the preparation for a new currency until after independence could have some value. A track record also has value, but that value should not be overstated.
Joining the EU comes with economic criteria including ‘macroeconomic stability (including adequate price stability as well as sustainable public finances and external accounts)’ and ‘proper functioning of the financial market (including financial stability and access to finance)’. These can form the basis of an economic policy framework. Given the importance of EU membership to the independence campaign, such a framework would have strong credibility with investors as a statement of what the Scottish government would do. As the reaction to Trussonomics has recently shown, a reputation based on what governments have done can be quickly lost.
The October 2022 currency proposal represents a meaningful departure from the 2018 recommendation of the Sustainable Growth Commission. Established by the First Minister and the SNP in 2016, the SGC recommended that an independent Scotland continue to use the UK£ for an extended period. In contrast, the recent Scottish Government paper accepts that an S£ would be in the best interests of an independent Scotland.
The proposals do not offer, however, a convincing case for retaining the UK£ for any period after independence. In particular, the proposals do not sufficiently account for recent developments in central banking in the UK and globally, which have increased the disadvantages of the proposed informal currency union with rUK relative to an immediate S£.
Advantages and disadvantages of an informal currency union
An informal currency union means Scotland would lack a central bank to create currency for monetary policy and financial stability purposes, while a new currency would give a Scottish central bank these powers. In contrast to the formal union proposed in 2014, an informal currency union with rUK means that the Bank of England would have no responsibility for monetary policy or financial stability in Scotland. Both monetary policy and financial stability now potentially involve the central bank creating money to buy government bonds. In monetary policy, this is Quantitative Easing, used to further stimulate the economy beyond setting interest rates at zero, but also highly influential on the UK government’s ability to borrow. In maintaining financial stability, this is buying government bonds to prevent the market from becoming dysfunctional.
QE began in the UK in March 2009 with the aim of raising inflation to the Bank of England’s 2% target. It was an ‘unconventional monetary policy’, with the reduction in the cost of borrowing a positive for the government but not central to the policy. During the pandemic, however, the Bank of England effectively met all the UK government’s borrowing needs for its health and economic response. Governor Bailey may have denied that the policy aimed to finance the government, but this was the outcome. Investors surveyed by the Financial Times believed that without the Bank of England buying, the UK government would have been unable to borrow the amounts that it did and, therefore, would have been unable to finance its pandemic response.
In an informal currency union with the rUK, the Bank of England would buy Scottish government debt only if it was deemed in the interests of the rUK. Scottish government borrowing would benefit to some extent from the overall decline in government bond yields from other central banks’ QE, but it would still face constrained borrowing and therefore a more limited capacity to respond to a future pandemic-type situation. But with a S£, the Scottish central bank could create money to buy its government’s debt, just as central banks globally did during the pandemic.
Continued use of the UK£ also precludes creating money to buy government debt for financial stability, as the Bank of England did in March 2020 and September 2022 after the Kwarteng ‘mini-budget’. In the latter case, the buying contradicted prevailing monetary policy. The mini-budget shock triggering the market collapse was UK-specific rather than global. It seems reasonable for a Scottish government to claim that they would never make Kwarteng-like policy errors, but they can only hope that an independent Scotland would not face other Scotland-specific shocks that threatened financial stability. But with a S£, the full central bank response would be available.
The transition to full use of a S£ would take time, with high use of the UK£ within Scotland even once the S£ is established, whether at independence or soon after. In my view, it should start on day 1 of independence.
For a fuller exploration of these ideas, see:
Iain Hardie, Twenty-First Century Central Banking and an Independent Scotland’s Currency Choice (Centre on Constitutional Change, 2022) and The SNP’s Currency Proposals (Centre for Constitutional Change, 2022). See also: Ben Wray, A monetary straitjacket…, sceptical.scot
First published by the Royal Society of Edinburgh under its Constitutional Futures Initiative and reproduced with permission
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