A pound of flesh - Scotland's dilemma

17 Jun 2018

On Friday the 24 May, the SNP’s Sustainable Growth Commission published its report, ‘Scotland – the new case for optimism.’ As the first step in strengthening the economic case for Scottish independence, it caused quite a stir. Coverage of the report varied but focused on the austerity measures required to lower the 6% deficit that Scotland would inherit. While the report’s bravery was praised, commentators questioned the acceptability of such measures to a Scottish electorate perceived to sit left-wards of their English cousins. 


The focus on austerity, however, left another questionable yet equally significant claim largely ignored: the currency arrangement of an independent Scotland. The report recommends keeping the pound sterling. Why does this matter? Such an arrangement was proposed during the 2014 referendum. And it is only the maintenance of the status quo. However, the consistency disguises the foolishness of this policy. To understand why, picture the following.


It is Scotland’s first Independence Day. The First Minister, Nicola Sturgeon, delivers a victorious, but notably understated, speech and negotiations commence. As promised, the pound remains Scotland’s currency for an extended transition period, though monetary policy is firmly in the Bank of England’s grasp. At first there are few problems. Scotland and the rest of the UK are closely aligned: with 300 years of shared institutional history and only a few decimals difference in unemployment. It is hardly Greece and Germany! But then the uncertainty moves in. 300 years of shared history means businesses find it easier to carry out their threatened relocations than they did for Brexit. Financial institutions (the importance of which the Commission itself notes) move toward London, attracted by the capital’s financial dominance and proximity to Threadneedle Street. Investment decisions are cancelled or put on hold. Unemployment rises. Scotland’s already lacklustre growth teeters and turns negative. The unlikely goal of 3.5% growth set by the Sustainable Growth Commission vanishes into the distance. The deficit widens.


Meanwhile, in the rest of the dis-United Kingdom, growth remains sluggish but acceptable. Any harm from the uncertainty emanating from Scotland is largely compensated by relocations. Unemployment remains stable at its historically low level. The greatest impact is a rising inflation rate from the speculative fall suffered by the pound on the announcement of Scotland’s independence. Rising inflation and low unemployment hastens the Bank of England on its path of monetary tightening. And interest rates rise.


Back in Scotland, the government is in crisis. Falling growth and a widening budget deficit has already pushed the government far from its ‘new case for optimism.’ With its own currency, a Scottish Central Bank could respond with a bout of quantitative easing and interest rate reductions, lowering borrowing costs for business and, more importantly, the government. Instead, the opposite is happening. While the Sottish government desperately tries to reduce a widening budget deficit, the Bank of England focuses on lowering inflation in the rest of the UK, reducing investment in Scotland and increasing the interest of Holyrood’s debt. With both levers of macroeconomic policy pushing down, Scotland’s economy shrinks even further.


In the end, the extended currency transition period turns into a lost decade. Rather than emulating Denmark or Finland, Scotland follows Greece, facing severe cuts to compensate for a lack of monetary sovereignty. By the time Scotland brings this extended transition to an end, the currency union has extracted its pound of flesh. A shadow of its former self, Scotland forms its new currency not as a new, proudly independent nation but an economic vassal crashing out of a failed project.


A dark picture? Certainly. But for all the Commission’s bravery in facing the fiscal cost of independence, it ducks the complexities of future currency arrangements - much as the SNP did when they dithered between the euro and pound in the 2014 referendum. Ceding control of its currency so apathetically is a serious mistake. Yes, other small nations have succeeded in currency unions like the euro. But they entered those unions in periods of stability, with strong growth and low deficits.


Scotland would be handing over an essential policy lever at a time when uncertainty means it needs all the options it can get. If it is to counter uncertainty with fiscal policy, then it needs monetary policy that will keep borrowing costs low. If it is to focus on deficit reduction, then it will need expansionary monetary policy to prop up growth. The way to have these options is for Scotland to have its own currency and central bank, the sooner after independence the better. Putting of that transition is not just weak politics, but dangerous economics.

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