Academic journal article National Institute Economic Review

Scotland: Currency Options and Public Debt

Academic journal article National Institute Economic Review

Scotland: Currency Options and Public Debt

Article excerpt

This paper considers which currency option would be best for an independent Scotland. We examine three currency options: being part of a sterling currency zone, adopting the euro, or having an independent currency. No currency option is the best when considered against all criteria. Therefore, making the decision requires deciding which criteria are most important. Recent events around the world, particularly in Europe, show that it is essential to consider how an independent Scotland would seek to adjust to adverse economic circumstances. In economists' terms, it is important to think through the 'off-equilibrium' adjustment paths of each of the currency options. The amount of public debt, and so the capacity for a fiscal response, is a critical determinant of these paths and therefore of the optimal currency choice. Since commitment to a currency union by an independent country can only be conditional, an independent Scotland might find it optimal to abandon the currency union in the future if the financial stability advantages to having its own currency begin to outweigh any disadvantages due to trade and transactions costs.

Keywords: currency union; monetary union; optimal currency area; debt sustainability; speculative attacks

JEL Classifications: E52; E58; F31; F33; F36; H60; H63; R113

"It is patently obvious that periodic balance of payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the international price system from fulfilling a natural role in the adjustment process."

Robert A. Mundell, A Theory of Optimal Currency Areas (1961)

Introduction

The choice of currency is integral to the economics of independence. It matters much more than simply the notes and coins in peoples' pockets. It determines how monetary policy is managed, whether there is any scope for exchange rate adjustment, the exposure to financial sector risks and even the scope for fiscal policy. In many ways, the choice of currency arrangement will determine the economic governance of an independent Scotland.

This paper considers the main currency options available to an independent Scotland. Each option offers a different trade-off between minimising exchange costs to support transactions across the border versus the scope for setting independent economic policy. The Treasury has argued that as long as Scotland is within the UK and there are fiscal transfers between regions, then it is optimal to have sterling as the single currency. The Scottish government has argued that if Scotland becomes an independent country, a sterling monetary union involving a joint governance structure of the Bank of England would be its preferred arrangement. (1) However, the Treasury has also repeatedly stated that it is unlikely to agree to such a monetary union. On this key issue the electorate is likely to be left with a stalemate.

In our view, it is not enough just to consider which currency option is most convenient for minimising the cost of transactions across the border. Recent events around the world, particularly in Europe, show that it is essential to consider how an independent Scotland would seek to adjust to adverse economic circumstances. In economists' terms, it is as important to think through the 'off-equilibrium' adjustment paths of each of the currency options. The amount of public debt, and so the capacity for a fiscal response, is critical to these paths. We argue that the amount of public debt is therefore critical to the optimal currency choice. There are enough examples of indebted countries in currency unions that endured destructive feedback loops and eventual severe recession to warrant full and thorough consideration. The welfare costs from the disorganisation which follows far outweigh any marginal effect on trade. A recent study by Laeven and Valencia (2012) shows that there have been 218 currency crises between 1970 and 2011, 65 of which coincided with sovereign debt crises. …

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