Scotching the Eurozone

LONDON – Which of the following events is more likely to happen this year: Scotland votes to secede from the United Kingdom in its September referendum, or at least one country decides to leave the eurozone? Conventional wisdom suggests that Scottish independence is possible, albeit not very likely, while any country’s departure from the single currency is fanciful.

But the decisions that Scotland would have to make about its monetary arrangements in the months following a vote for independence are at least as likely to be confronted by some eurozone countries over the next couple of years. In fact, there is a natural link between the two situations.

An independent Scotland’s continued use of the British pound – the Scottish government’s official position – could be approached in two ways. The first possibility, which First Minister Alex Salmond appears to have in mind, would entail a monetary union under a central bank accountable both to Scotland and the rump UK.

But the UK government could – and undoubtedly would – veto any such adaptation of the Bank of England’s responsibilities for monetary policy, financial stability, and banking supervision. Any other conceivable model of monetary union – including one based on a central bank as unaccountable as the European Central Bank – would be subject to the same rejection. As the journalist Martin Wolf noted recently, “the rest of the UK has surely not escaped the horrors of the eurozone only to create similar horrors for itself at home.”

The alternative for a fully sovereign Scotland would be to continue using the pound without retaining any influence over interest rates or the exchange rate. This was the path taken by the Irish Free State (later the Republic of Ireland), which used the sterling-pegged “Irish pound” (the punt) for several decades. Even if the UK disapproved of the arrangement, it could not stop Scotland from adopting it – much as the European Union deplores but cannot stop Montenegro’s unilateral use of the euro.

While the decision would have a significant political downside – that is, immediately diluting Scotland’s newly acquired sovereignty – its economic implications are mixed. Borrowing the credibility of an established monetary authority – especially one that issues a global reserve currency – would be tactically advantageous for a post-independence Scotland; but the new country would be exposed to the risk of an inflation shock and sterling crisis stemming from the Bank of England’s expansionary monetary policy.

From a fiscal perspective, the case is similarly balanced. The interest-rate premium that the market would inevitably demand from a young sovereign like Scotland could be minimized by issuing debt in sterling, thereby protecting investors from additional devaluation risk. But, without its own currency-issuing central bank, Scotland would forego seigniorage (profits from central-bank operations that typically benefit the national treasury). Perhaps more important, it would have no lender of last resort capable of stabilizing the banking and financial system in a crisis.

All things considered, an independent Scotland would be best served by issuing its own national currency from the outset, empowering the National Bank of Scotland to set interest rates according to domestic economic conditions. By allowing for exchange-rate flexibility, this approach would also enable the central bank to avoid the twin hazards that arise in a currency union: undervaluation, which produces inflationary pressure, and overvaluation, which demands wrenching internal devaluations (driving down real wages).

To see just how difficult the latter can be, consider the eurozone. The agony of internal devaluation in the currency union’s weaker economies is increasingly driving voters and financial markets alike to call for a return to their national currencies – a trend that may well come to a head in May’s European Parliament election.

Italy is perhaps the prime candidate to lead an exit from the eurozone, though a political shock could also arise in France, spurring it to negotiate with Germany the dissolution of the monetary union. But, regardless of who leaves first, any countries trading in the euro for their defunct national currencies would, like an independent Scotland, have to determine the right degree of exchange-rate flexibility.

For example, while a fully floating currency would create a beneficial combination of discipline and flexibility, it might best be delayed in favor of an adjustable (“crawling”) peg to some anchor currencies. This would buy time to build credibility and, more important, to help keep public debt under control.

An instructive precedent is Slovakia, whose “velvet” divorce from the Czech Republic at the beginning of 1993 led to the creation of a new national currency. The Slovak koruna was initially kept within pre-defined fluctuation bands around target parities with the Deutsche Mark and the US dollar, before moving to a fully floating exchange rate in 1998.

Furthermore, Slovakia, unlike most of its regional peers, has fulfilled its legal obligation to join the eurozone ��� an obligation that an independent Scotland would have to take on when, as expected, it sought EU membership. But a sovereign Scottish government might try to negotiate an exemption to this rule – and, in so doing, join the tide of other European countries seeking a way out of the great blunder that Europe’s monetary union has turned out to be.