Back in April, the Treasury published a report explaining, in short, that an independent Scotland could not be a member of a currency union, managed by the Bank of England, without considerable fiscal oversight. The Scottish National Party (SNP) dismissed this report as ‘scaremongering’.
In this post, I want to reiterate why the Treasury was right, and if anything understated the problem, (probably scared itself of being accused of scare-mongering). The SNP’s failure to address this important issue of institutional design reveals either incompetence on their part, or, worse, indifference to the future macroeconomic stability of Scotland and a determination to make sure that the Scottish electorate don’t grasp the issue. 10 years ago, this debate would have been much less clear cut because we did not have the example of the euro area on our doorsteps. Now, however, we can see clearly what happens when countries combine to form a currency union, but have independent fiscal and financial stability policies.
The short answer to this question is: without intrusive fiscal oversight, the currency union of the Rest of the UK [or RUK] with Scotland would look like the currency union in the Euro Area. Not good! In fact, even worse, because the size of the balance sheet of the banking sector in Scotland relative to GDP is much higher than say, the typical basket case Mediterranean country. And worse too because the exposures to Scottish banks of the UK probably exceed those of the European core to the periphery. So, it seems pretty clear to me that the RUK would not want to sign up to a currency union on these terms, contrary to the SNP’s assertions.
To spell things out a little more: the RUK would want to ensure two things. First, Scotland supervised its banks to the same standard as the RUK supervised its system. Second, that Scottish fiscal policy was sufficiently conservative as to be able to cope with a failure of its banks. Otherwise, in the event of a crisis, there would be irresistable pressure (just as for the European core now) to offer a bail-out to Scotland, so that it in turn could protect Scottish banks, and thereby protect RUK banks from a run as a result of worries about exposure to the affected Scottish institutions. Without these two guarantees in place, there would be every incentive for the Scots to free-ride on UK financial guarantees. The Scots might be tempted to offer lax capital or oversight, in the hope of retaining or attracting further domiciled banks, and obtaining the tax revenues that come with it, while relying on the incentive of the RUK fiscal authority to bail it and its banks out in the event of a crisis. [This is one way of reading Salmond’s response to the proposed acquisition by RBS of ABN Amro. He welcomed it because it beefed up the profits that would be billed to Scotland, and the tax revenues that he could argue should be hypothecated for Scottish spending].
This problem would be less severe if Scotland were forced to manage its own currency and exchange rate against the RUK, because Scotland would have the option of plugging the gap in its finances by printing that currency, and the fall in the currency that would be associated with a financial-sovereign crisis would stimulate export-led growth (just what the European periphery are lacking now). The knowledge that such an option exists would put an (inflation risk) premium on Scottish government bonds, but it would also lessen the likelihood of a run on those bonds and the banks that held them.
This is why the RUK government would not be content to maintain a currency union with Scotland without tight fiscal and financial stability oversight, which, in effect, amounted to a fiscal union. And the reasons, to repeat, are almost identical to those governing the struggle over how to work through the European crisis. Scots voting for political independence in order to achieve fiscal independence should not count on remaining part of the Sterling currency union.
Even with a floating currency, there would still be some incentive for a RUK government to offer aid to a Scottish sovereign having difficulty financing a bail out, or guaranteeing Scottish deposits to prevent a run on Scottish banks, and an associated plunge in demand for RUK exports to Scotland. (The funding for Ireland during the euro area crisis that the UK offered was not for altruistic purposes). And knowing this, there may well be some incentive to free ride in advance (with lax regulation and higher tax revenues accruing). So from this perspective only, namely, to ensure a watertight financial stability union, while Scottish and RUK banks are so intertwined, RUK voters should hope that the Scots vote no.
The analogy with Europe isn’t perfect. One of the reasons why Germany has not yet pushed to cut Greece loose is because of the precedent that might be set for Portugal, Spain, even Italy, and the worry that default and exit by these countries might become a self-fulfilling prophecy. There would not be the same problem for a RUK contemplating kicking out Scotland from a currency union in the event of a financial crisis. There would be no further entity within the currency union that might have to break away. For that reason it would be less traumatic for the RUK to force a Scottish exit in a crisis.
Another reason why the analogy isn’t perfect is that a currency union with an independent Scotland would happen with the experience of a Euro Area crisis fresh in everyone’s minds. One would presume that the real possibility of a break-up of the Scotland/RUK union would make a break-up itself less traumatic. For one thing, RUK banks would think carefully about the price they wanted to pay for Scottish bonds, and would not treat them as substitutes for RUK ones, as it appears that markets in general did when pricing euro area core and periphery bonds in the run up to the crisis.