Thursday, November 27, 2014

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?

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    1. CommentedMargaret Bowker

      Glad to see the three UK leaders' signed pledge in the Daily Record on new extended powers for Scotland and on the NHS.

    2. CommentedWalter Gingery

      The Financial "Times" published on Sept 5th an article titled "Scotland's Currency Future: What Economists Think." Asking a panel of economists what would be most desirable for Scotland -- 1) continued banking union with the UK, 2) continued use of sterling without backing of Bank of England, 3) its own, separate currency, or 4) the Euro -- (not what is likely to happen), they disagreed about which would be most desirable. However, they ALL agreed, WITHOUT EXCEPTION, that the worst option for Scotland would be adoption of the Euro.

    3. CommentedMargaret Bowker

      Have suggested a Memorandum of Understanding before the referendum, as a start off point for the increasing of Scottish powers.

    4. CommentedChee-Heong Quah

      Well, the fundamental question is not whether to stay with London or to join euro zone. The question is about to leave the monetary powers to whom? To centralized power or to the people? It's about top-down or bottom-up approach. Central powers corrupt and fail. Abolish central banking. Bring back the money to the private market. Let the public choose, whether to use bitcoin or other private money as the unit of exchange. Check out Misesian works on this.

    5. CommentedMargaret Bowker

      Well, it's only been one poll so far indicating a risk of Scotland leaving the Union and the answer to Professor James's question is no. Perhaps raising this issue will soon be academic. The offer for new powers on tax, welfare and job creation is due out this week and perhaps it will take the big bazooka of Devo Max to settle this.

    6. CommentedKaySoon Lim


      Assuming Scotland achieved independence, her initial option may opt for an independent Scot Unit, peg either to EUR or GBP, back by her petrol and gas reserves and resources, without the need of approval from the respective authorities. IMF should be able to provide the initial support if needed. This initial approach would provide calm and stability of the Scot Unit to serve Scottish economy.

      As for overcoming the problem of overvaluing or undervaluing the Scot Unit, instead of trying to manipulate the Scot Unit, fiscal policies should be used to manage the different industries within Scottish economy. For example, if due to low interest that could cause housing inflation and construction, taxes and other regulations can be implemented to prevent overheating and vice-versa, if needed.

      In the longer term, Scotland will have to find her own footing on whether she should align her economy to the English or the Europeans' economy through fixing her currency to it. If EUR is the preferred choice, then Scotland should negotiate with the EU to be part of the EUR so as to benefit from the currency exchange efficiency.

    7. CommentedWalter Gingery

      The solution to the problem as outlined here is clear: not Scotland, but London, should leave the sterling zone.
      The pound, just like the Euro, is a composite. And just as the Euro confers on Germany the competitive advantage of an undervalued currency, so does the pound on London. In effect, Britain's other regions subsidize London's exports and penalize their own. To compete with London, it is necessary to separate the regions from London. London deserves a separate, independent currency, like Hong Kong and Singapore.