I think the current rumpus about future Scottish currency arrangements serves to illustrate important general points about how national currencies can work for their people or fail to do so. Scotland is due to vote in a referendum on independence from the UK. Like many people in the UK, I have mixed Scottish and English ancestry and have family in both countries. I’ve lived in Scotland for a few years in the past but I consider myself English and I’m writing this as an English person. I have no objection to Scottish independence and I can see that it makes a certain amount of sense since people in Scotland so often vote differently from those in England and have a distinct national identity. On the whole small countries seem just as able to provide their citizens with an affluent lifestyle as do large countries. Basically I don’t mind either way if Scotland chooses to split from the UK or chooses to stay. However, if they choose to split, I’d like the split to leave all of us with a monetary and political arrangement conducive for continued prosperity and harmony.

Alex Salmond hopes to have a currency union between a future independent Scotland and the UK. I’m vehemently against my country being in a currency union with any other country -whether with the Euro or with some new sterling currency union between an independent Scotland and the remaining UK . The fact that the Euro currency union was broken by design was apparent as soon as the idea was proposed. As Wynne Godley wrote in 1992,

 It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates. As local authorities possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there. 

The ongoing Euro crisis has confirmed the foolishness of having monetary union without fiscal, banking and political union. Greece now has a staggering level of unemployment and relationships between previously friendly Eurozone countries have become fraught.

Within a country, if one region suffers a localized economic downturn, then that region will typically end up paying less in taxes whilst receiving more in terms of central government spending. That automatic fiscal stabilizer effect helps to prevent a downward spiral from taking place where a small downturn becomes amplified into a prolonged depression. Currency union without fiscal union exposes a country to just such a pointless and destructive feedback effect. The crucial problem for the eurozone is that deficit spending in each eurozone country is financed by selling national bonds BUT spending by say the Italian government can end up in the hands of people buying say German bonds or paying German taxes. That money is then not available to fund the Italian government. By contrast, spending by the UK government will circulate around until that money gets spent on buying UK government bonds or paying UK taxes. There is no other way for that money to leave the UK system. The exchange rate between the pound and other currencies may be at risk if the UK acts irresponsibly, but the UK government will never have any nominal funding difficulties so long as we keep a sovereign currency arrangement (I’ve summarized an overview of our monetary system on page 12 of this pdf). A currency union breaks our sovereign currency arrangement.

It is crucial to note the distinction between a currency union and a situation such as that of Montenegro or Ecuador where foreign currency is used as money.  The government and people of Montenegro use the Euro as money and the US dollar is used in the same way in Ecuador. Clearly Scotland could bizarrely choose to use the UK pound in a similar fashion but that is not what Alex Salmond is proposing. Alex Salmond is proposing a sterling currency union with a supranational central bank akin to the Euro currency union. Montenegro is not part of the Euro currency union and the European central bank provides no support for Montenegro. All of the Euros in Montenegro were aquired in exchange for goods and services sold to Eurozone citizens. In effect Montenegro’s arrangement has given the Eurozone a free lunch. The European Central Bank has belatedly provided some support for Spain and Italy, buying government bonds so as to keep yields and financing costs under control. Montenegro has no such backstop and Montenegro has no central bank with fiat currency capabilities. But any problems that Montenegro may encounter do not become the responsibility of the eurozone. By contrast, Alex Salmond’s proposal would radically change the monetary arrangements for the remaining UK. We would no longer have our own central bank beholden to us. The actions (or lack of actions) of the central bank would become a fraught source of unaccountable political  squabbling just as in the eurozone.

In my view if Scotland wants to become independent then it needs to adopt its own currency. Scotland is no smaller than some other successful developed countries that have their own currencies. Scotland  has a population of 5.3 million whilst New Zealand has 4.4 million; Norway 5 million; Singapore 5.3 million; Switzerland 8 million and Iceland only 320 thousand. Undoubtedly, Scotland could remain a prosperous country and a valued trading partner with its own currency. However we would then have the issue of how to apportion the current  outstanding UK sovereign debt. Alex Salmond has threatened to repudiate Scotland’s share of that debt if the UK refuses to enter into a currency union with Scotland. I think it is crucial that UK treasury debt does not degenerate into becoming a high yield mess such as happened with much of the Eurozone debt. This issue is too important for it to be used as a weapon for political brinkmanship between those wanting and those resisting Scottish independence. It would also be a disaster if Scotland had its own currency and yet also had a burden of sterling denominated (and so foreign currency) debt. That situation would be akin to how Haiti started off independence with a burden of debt to France. Foreign currency denominated debt has no place in responsible governance. When the UK stupidly took on US dollar denominated debt in 1976 it swiftly lead to the IMF crisis.

Just as currency converted when countries joined the Euro, bank accounts, bank reserves and debts in an independent Scotland could switch to being denominated in Scottish currency. Likewise Scotland’s share of the UK treasury debt could also switch to being denominated in Scottish currency. Obviously people who bought outstanding UK treasury debt did so on the understanding that it was sterling denominated. It would be well worth avoiding compromising the UK treasury debt market. However £375Bn of UK treasury debt is owned by the Bank of England as a consequence of the quantitative easing activity of recent years. That UK treasury debt on the Bank of England’s balance sheet has a counterpart in the form of bank reserves and those have a counterpart in the form of customer bank deposits. Upon Scottish independence, all of the bank reserves that switched from being sterling denominated to being denominated in Scottish currency could be mirrored by debt transferred from the Bank of England to a new Scottish central bank and switched into being denominated  in Scottish currency. There would nevertheless still be some remaining share of the debt to deal with. To my mind the best approach would be for new Scottish currency denominated debt to be issued and transferred to the UK government’s foreign currency reserves. So the UK government would keep more than its “fair share” of the UK treasury debt liabilities but it would be compensated with new Scottish treasury debt that would be serviced with interest payments payable in Scottish currency. Scotland would then have a robust sovereign monetary system allowing the Scottish government to facilitate an effective Scottish economy. It would also avoid leaving the remaining UK short-changed and ensure that Scotland provided us with a prosperous trading partner.

Related previous posts:

Political Consequences of Risk Free Financial Assets

Global Reserve Currency Status Matters

Related stuff on the web:

Scotland and a Currency Union -Open letter from UK Treasury Permanent Secretary Nick Macpherson

Alex Salmond Speech on Currency Union

The eurozone shambles has been the worst setback for European integration since the 1940s- Tim Congdon

Target2-Window on Eurozone Risk-JKH

Excluding Scotland from currency union is demeaning and insulting claims Alex Salmond -Telegraph

Scotland analysis: Assessment of a sterling currency union -UK treasury

Scotland’s Future -Scotreferendum.com

The Economics of Currency Unions -Mark Carney-Bank of England

Maastricht and All That -Wynne Godley 

The Russian Default – What Happened -Cullen Roche

ECB introduces unlimited bond-buying in boldest attempt yet to end euro crisis.-Guardian

Adding the Central Bank-Eric Tymoigne and L Randall Wray

Debt, Deficits and Modern Monetary Theory -Harvard Review interview with Bill Mitchell

UK’s Official Reserves -Bank of England

 Sterling devalued and the IMF loan -Cabinet Papers