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Whistling in the wind

3 February 2014 By Hugo Dixon

An independent Scotland will not keep the pound. That’s despite this being the express wish of the Scottish government, which is campaigning for independence in September’s referendum. The reason is that it’s hard to see the rest of the UK agreeing to such a deal – except on terms that would affront Scotland’s amour propre.

One can understand why Edinburgh is keen not to change its monetary arrangements. If Scotland had its own free-floating currency, it would be less economically integrated with the rest of the UK. Given that 60 percent of its exports and 70 percent of its imports are with the rest of the UK, such a separation would hit hard.

A separate currency would also cause trouble for the outsized Scottish banking sector. Banking assets are more than 12 times GDP – nearly double the ratio for Iceland, Ireland and Cyprus before their banking industries blew up. The Scottish people might also worry that a Scottish currency could fall in value, devaluing their savings.

Joining the euro might not be any better. Like a separate currency, the euro would complicate Scottish trade with the UK, and the euro zone might be unhappy with Scotland’s relatively gigantic banks. Added to that, the euro has suffered years of terrible publicity, so promising to join it wouldn’t be a vote-winner.

No wonder Alex Salmond, Scotland’s first minister, is pledging a currency union with the rest of the UK. The snag is that such an arrangement would be virtually impossible to negotiate. Mark Carney, the Bank of England’s governor, gave some of the background thinking in a speech in Edinburgh last week.

Carney pointed out the dangers of having a currency union without the necessary institutional framework, using the euro crisis as a cautionary tale. For a start, there would have to be a so-called banking union – involving common supervisory standards, access to central bank liquidity, common “resolution” mechanisms and a credible deposit guarantee scheme. He also argued that there would need to be “tight fiscal rules, to enforce prudent behaviour for all in the union.”

Carney pulled his punches. A successful currency union would require far more than this.

For a start, it would need a mechanism to prevent the union breaking apart in response to destabilising speculation. The euro zone struggled for nearly three years until Mario Draghi pledged to “do whatever it takes” to keep the currency together.

Would the rest of the UK really be prepared to do whatever it takes to keep Scotland in the sterling area, after its people had decided they didn’t want to be part of the UK? The Scottish government has made the task harder by saying that it might not want to keep the pound in the long run anyway. That lack of commitment could attract speculators like red meat attracts sharks.

Then there’s banking supervision. Common supervisory standards wouldn’t be enough. If the Bank of England was going to act as a lender of last resort to Scottish banks, it would presumably want to supervise them too. Even the euro zone has got round to that conclusion.

Another knotty problem surrounds unorthodox monetary policy such as quantitative easing. One of the reasons the UK and the United States are growing faster than the euro zone is that their central banks have been free to pursue such policies. The European Central Bank, by contrast, has found it hard to engage in quantitative easing because it is banned from bailing out individual governments.

It’s hard to see the UK giving up such useful tools. But it is equally hard to see why it would accept the possibility that it might have to bail out an independent Scotland. On the other hand, the Scots would feel they weren’t being treated fairly if the central bank refused to use quantitative easing to buy Scottish assets.

A similar thought applies to budgetary rules. While the rest of the UK would want to put Scotland in a fiscal straitjacket, it wouldn’t want to limit its own freedom. The Scots would feel snubbed by such an asymmetrical deal.

Then there’s the question of how the Bank of England would be governed. Given that Scotland’s economy and population are about 10 percent of the whole UK, one option would be to give it one member on the Bank’s monetary and financial policy committees for every nine from the rest of the UK. The snag is that it could then always be outvoted.

An alternative would be to copy the euro zone where every country – whether as big as Germany or as small as Malta – gets the same vote. But why would the rest of the UK agree to that?

Salmond has threatened not to take on Scotland’s share of the UK’s debt if it is not allowed to join a currency union. But playing tough with a country that is nearly 10 times its size doesn’t seem sensible. If it comes to tit-for-tat, the rest of the UK can hit Scotland much harder than Scotland can hit it. London could, for example, stop Edinburgh joining the European Union.

The only currency union to which it would be rational for the rest of the UK to agree would be a lopsided one where Scotland’s subservient role was glaringly apparent. Given that, one wonders whether the Scots wouldn’t be better off just staying in the UK.


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