Independent or not, Scotland needs the pound
The United Kingdom has been one of the most stable and prosperous economic unions in history. The UK came into existence in 1707 with the Act of Union between England and Scotland - with Wales being under English control since 1284. Even before Union England and Scotland had common resources and institutions – including shared Monarchs since 1603, and, of course, the pound. Indeed, the Banks of England and Scotland have shared the pound for the last 300 years. Well before formal currency union the Scottish pound was tied to the English pound to stabilise its value in the wake of a series of devaluations in the 17th Century. While Scottish independence throws up many, as yet unanswered questions, it is the situation regarding Scotland’s currency which remains the most unclear, and is one which must be quickly decided after Thursday – should the vote endorse separation. As everyone seems aware, uncertainty over the currency is the single most problematic short run issue facing Scotland – and the rest of the UK.
As economic theory predicts, countries that share a currency, a central bank and a single interest rate (not to mention common tax and revenue policies) are likely to converge, and this is certainly the case across the UK. The integration of Scotland and England’s economies during the 17th and 18th Centuries made a shared currency an unquestionable necessity, and the greater the integration the more important a common currency became for the joint prosperity of the UK. As the decades rolled on, and despite regular economic shocks, including poor harvests, famine and a devalued Scottish pound, the convergence continued.
Of course, the world has changed beyond recognition since industrialisation, when Scottish and English prosperity was forged out of a common industrial base, and where the UK became the powerhouse of the modern world, with Scotland arguably its intellectual centre. Union for Scotland enabled Scottish industry (notable textiles, and later shipbuilding and engineering) to have access to the wider Commonwealth and Empire, and to benefit from free trade. It is undoubtedly the fact that trade is created when trading partners share a common currency (and a common market), and with Scottish exports to the rest of the UK around 50%, anything which makes trade more difficult and more costly will not only reduce trade, but will have widespread knock-on effects around the macro and micro economy of Scotland.
Deindustrialisation and the rise of the knowledge economy has substantially changed the nature of economic activity – both in the UK and around the world – since the 1970’s. The post-war period saw both England and Scotland respond to deindustrialisation by strengthening their position as centres for financial services, and both have jointly shared considerable prosperity since financial deregulation and the ‘big bang’ – the financial crisis notwithstanding. Added to this, the exploitation of North Sea oil, from 1970, further enabled Scotland to protect itself from deindustrialisation. Economic convergence has continued, so that one can hardly get a cigarette paper between the English and Scottish economies. For example, in terms of disposable income per head, Scotland’s £20,571 rests slap-bang in the middle of income distribution across the UK regions. Public spending per head is £12,300 in Scotland compared with £11,000 in the rest of the UK, while unemployment runs at 6.4% in Scotland against 6.8% across the UK. Despite media accounts to the contrary, benefit spending in England and Scotland is virtually identical. In terms of inflation, Scotland is consistently 1% below the average rate for the UK. But none of this is a surprise, given how closely interlocked the two economies are.
So, without monetary union the most likely outcome of Scottish independence is that the Scottish and English economies will start to diverge, following a path dictated by economics, demand and supply, and the application of the principle of comparative advantage. Comparative advantage does, of course, change over time as existing resources and skills go into decline and others appear. Indeed, as oil runs out the hope in Scotland is that it can develop its knowledge based economy even more – this is certainly a possibility, given the attraction of its free universities to its brightest, and its long history of intellectual, scientific and technical excellence. For every bank that flees to London there are likely to be several high-tech foreign investors looking to exploit Scottish talent. That is, of course, in the longer term – for now, the medium term depends on what currency Scotland will adopt.
Whether Scotland introduces a wholly new one, adopts the Euro, or continues to use Sterling ‘unofficially’ – a process called sterlingisation (aka Pan B) – will shape Scotland’s prospects for decades to come. Adopting either of the latter two would mean that Scotland could not set its own interest rate. The problem with Plan B is that, by all accounts, it would create problems for an independent Scotland’s future membership of the EU. Indeed, it is a requirement of any country looking to join the EU that they have a central bank to control interest rates and the money supply. This is not to say that Plan A – a negotiated sharing of the pound – will not happen after a Yes vote. However, the issue of who will be the lender-of-last-resort in an independent Scotland is a very thorny one. The Scottish government could fill the role, in the short run, with support from the IMF (or even the ECB) if required. A new Scottish deposit insurance fund would be required to bring some certainty to the financial system in Scotland. Without this facility, Scottish banks will head south, as indeed several have indicated.
Without a formal negotiated currency union - Plan A - there is likely to be an increased role for fiscal policy, which may have to be more active in the event of an economic shock. Given that the Bank of England is unlikely to act as lender of last resort, Scottish banks would need to keep more reserves. Of equal significance is precisely how, in the negotiation process, the UK’s assets and liabilities will be apportioned. Both sides have been ‘getting their points in early’ in an attempt to get the best deal for their citizens.
Of course, currency stability is essential to create the right anti-inflationary environment, which a new Scotland will certainly hope for. Which brings us to prices. A chorus of business leaders have indicated that rising costs are likely, depending ultimately on six key areas. Will taxes rise, will regulation become less business friendly than in the rest of the UK, will markets become less competitive, will there be fewer economies of scale for sellers in a smaller Scottish market, will cross-subsidisation (from the rest of the UK to Scotland) be restricted, and, of course, with the ‘new’ currency be so weak as to push up costs (or indeed will the whole independence issue drag down sterling anyway?) The answer is, probably, yes to most of these questions - which takes us back to the currency issue. The best guess is that, if the vote is Yes on Thursday, the Scottish and what’s left of the UK governments will have to sit down and work through a detailed plan to enable Scotland to continue to use the pound officially. A brand new currency would be a waste of everyone’s time and money, and adopting the Euro is clearly out of the question. So if Scotland is to use the pound, at least make it official, open and transparent. The sooner these negotiations are complete, the quicker we can return to some kind of normality – a ‘new’ normality, that is!