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Should Scotland Leave the Pound Zone?

PRINCETON – As Scotland prepares for this month’s referendum on independence, the United Kingdom – indeed, all of Europe – must brace itself for the impact of a successful bid. Scottish independence would revolutionize the British and European constitutional frameworks, and give a tremendous boost to other European separatist movements, from Catalonia to northern Italy. The economic impact of independence, however, is far less certain.

Advocates of independence have long insisted that they are motivated primarily by the distinctiveness of Scottish identity. But Scotland’s history and traditions, while undoubtedly its own, have been shaped by centuries of interaction with England and other parts of the British Isles.

The more immediate issue for Scots is money. The question of whether an independent Scotland could or should continue to use the British pound has dominated discussions over the last few months of the referendum campaign. The outcome – for Scotland, the UK, and Europe – could vary widely, depending on which path Scotland chooses.

So far, Scottish nationalists have insisted that an independent Scotland would retain the pound. But, given how much easier it would be to make the case for a separate currency – not to mention the fact that Chancellor of the Exchequer George Osborne has explicitly rejected Scottish First Minister Alex Salmond’s proposed currency union – such declarations amount to an own goal.

The problem with the Scottish nationalists’ vision is a mirror image of the eurozone’s main shortcoming. Given that a single currency cannot function without a common monetary policy, and that economic conditions across the currency union differ, individual members will, at times, be subject to unsuitable policies.

For example, during the construction boom of the 2000s, Ireland and Spain should have had tighter monetary conditions, higher interest rates, and lower loan/asset ratios. But their eurozone membership meant that government and private-sector borrowers alike benefited from very low interest rates. After the financial crisis erupted, and policymakers began seeking ways to compel banks to revive lending in these and other struggling countries, it became apparent that there were no available tools to employ.

Today, the UK faces a similar dilemma. The property boom in the London area demands tighter monetary conditions. But higher rates would wreak economic havoc on the rest of the country, where the recovery remains anemic.

Moreover, like Germany, London maintains a huge current-account surplus (8% of GDP) – a potentially serious problem, given the deflationary effect that Germany’s surplus has had on the rest of the eurozone. Already, the rest of the UK runs an external deficit that is higher than that of any industrialized country.

The behavior of a currency can be driven by one powerful and preeminent sector of the economy; in the pound’s case, it is the financial sector. Some viewed the pound’s rapid decline in 2007 and 2008 – a 30% depreciation in trade-weighted terms – as a much-needed economic stimulus, given the boost that it implied for export competitiveness. The UK’s independent monetary policy provided it with a level of flexibility that the eurozone economies lacked. 

But the revival of confidence in the financial sector has caused the pound to rebound sharply (by 18% since the end of 2008), eroding the UK’s competitiveness gain. What is good for the City of London is not necessarily good for the rest of the economy.

There is thus an unmistakable appeal in escaping an economic arrangement that shackles Scotland to London – an appeal that the great Scottish economist Adam Smith would have recognized. Indeed, his most influential work, The Wealth of Nations, was motivated by the belief that the interests of the London merchant community were distorting British commercial policy.

The alternative to retaining the pound, however, presents its own challenges. According to the Scottish economist Ronald MacDonald, an independent Scotland should have its own currency, which would behave like a petro-currency, owing to the economy’s dependence on North Sea gas and oil.

But replacing one dominant sector with another is probably not good for the rest of the Scottish economy, which would lose competitiveness whenever surging energy prices pushed up the exchange rate. As less competitive industries were driven into loss and insolvency, economic activity would become even more concentrated and specialized.

Placing the burden of adjustment on the exchange rate is not the answer. The small, open economies of Switzerland and Norway – important models for Scotland – struggled with sharp currency appreciation during the global financial crisis. For Switzerland, the solution was to implement a ceiling on the franc’s exchange rate against the euro.

This should inspire Scotland to pursue association with a larger currency area and a more diversified economy. How about adopting the euro?