The recent debate over the currency to be used by an independent Scotland has been drearily familiar. The Yes camp point to the report of the Scottish Government’s Fiscal Commission and claim that the case for a currency union is so blatantly obvious, based as it is on “common sense”, that no other solution can possibly be contemplated. The No campaign retort that the flaws in the design are so apparent, and the alternatives so non-existent, that Scotland alone of all developed countries will be unable to create an appropriate currency framework, with bankruptcy the presumed result. The UK Government continues to make blatantly politically motivated threats of non-cooperation which few believe would actually be followed through once the voted have been counted. At least the old canard about an independent Scotland being “forced to join the Euro” seems finally to have been dropped: the proponents of this absurdity presumably have either finally got around to reading the Treaty on the Functioning of the European Union, or have come to the conclusion that this is a whopper too far, given the existence of Sweden as clear counter-evidence.
While I understand the desire to reassure people that the arrangements for a newly independent Scotland have been worked out and are set in stone, thus quenching the public thirst for “certainty” (a dubious prospect in any democracy), it seems to me that all sides, but particularly the Yes campaign, were trying a little too hard: not just to provide certainty for the immediate future but to provide certainty for the long term, with the defence of the currency union proposal just a tad too vehement. (One can also question the dogged fanaticism of their opponents in seeking to expose any tiny flaw in the design, as if this would supposedly invalidate the whole argument. And by the way, where will UK interest rates be in five years? Tax rates?) No one seriously doubts that in the short term Scotland will be retaining sterling: there is a long track record of newly independent countries maintaining their old currency for the purposes of transition. This ranges from one month after independence in the case of the Czech Republic and Slovakia, to a year for Estonia, to twenty years for the Australian pound to become de-linked to sterling (1910 to 1931) and over fifty years in Ireland, who did not break the one-for-one link with the UK pound until the joined the Exchange Rate Mechanism in 1979. As the Fiscal Commission has shown, there is a strong case for currency union in the economic circumstances which Scotland finds itself: England would be a major trading partner and currency union eliminates exchange risks and losses. Due to the integrated nature of the labour market, similar business cycles and parity in productivity and income levels, “one size fits all” policy-making in normal economic times does not pose the same risk that, say Portugal faces in its currency union with Germany.
However, it is incumbent upon those engaged in the debate on Scotland’s future to consider our best long term interests as well as our immediate ones. After all, economic circumstances can change – sometimes, drastically – and thus the most appropriate policy will change as well. And there is a definite need to challenge the assumption obscuring the importance of this debate: that monetary policy is safe to leave to others as it is inherently not political – that it is technical engineering best left to experts in central banks, and the less political interference by blundering politicians and rabble-rousers, the better. This view is based on some admittedly horrendous examples of political interference in the currency, with horrendous economic consequences: hyperinflation in Germany in 1923, caused by the decision of the government to print money in response to the French occupation of the Ruhr, is the best example. It is also true that the crisis has shown the limits of monetary policy, with interest rates pushing the zero bound and quantitative easing failing to reverse the slump. Fiscal policy must come into play as well, and it is the precise lack of fiscal policy support due to austerity which has proven most controversial and political.
Nevertheless, monetary policy can be as political as any other aspect of economic policy. After all, what is the setting of interest rates but a choice between supporting savers and supporting borrowers, or between tackling inflation or boosting employment? There is also an implicit choice between financial and industrial capital: while John Maynard Keynes forecast the euthanasia of the rentier through permanently low interest rates, the high rates of the early 1980s proved disastrous for UK and American manufacturing. It has been noted that while the US Federal Reserve has an explicit remit to tackle employment, the European Central Bank does not: this has real world implications. The decision of the ECB to raise interest rates in the summer of 2011, on the grounds that the recession was over and that inflation needed to be tackled, while the Federal Reserve was providing long term certainty for low interest rates in the US, surely is not coincidental to the respective economic performance of the two super-blocks. In addition, the two-year agonising of the ECB over whether to support (i.e. reduce) the interest rates paid on government bonds by distressed Mediterranean countries through purchase of these bonds in the secondary debt market (the so-called Outright Monetary Transactions, a dilemma which was finally resolved by Mario Draghi’s statement last summer that the ECB would do whatever it takes to support Spain – a promise which has not had to be fulfilled yet) was due to the inherently political nature of the decision, which would in effect transfer wealth from one Member State to another. The ECB felt that, in order for true popular legitimacy, this was a decision best taken by – politicians.
So the implications for Scotland of monetary policy decisions are potentially profound: perhaps not so much in ordinary times, but definitely in difficult economic times when bold action is required. Notwithstanding the undoubted benefits of having no exchange transfers with our largest trading partner (though independence will surely offer us the opportunity of developing new markets), the case for a separate Scottish currency, on pure “flexibility of policy-making” grounds, has a lot to argue for it. It is certainly superior to another option which has been proposed, that of sharing a currency with the UK without their consent, which would imply giving up monetary policy control entirely. This is the equivalent of the actions of a number of countries, such as Argentina, who chose to peg their currency to the dollar to promote “stability”. The results were disastrous: the peso became over-valued by the late 1990s and Argentina lost competitiveness in its critical export markets, contributing to the collapse which occurred in 2001. Parity with the pound without policy offsets would also potentially entail the sort of currency strength which proved lethal to manufacturing in the 1980s.
Advocating an independent currency on the grounds of controlling interest rates is only part of the story: though an important chapter, as demonstrated by the ECB’s artificially high rates in 2011. There are several other elements. First, financial regulation. The Scottish Government’s Fiscal Commission notes that macro prudential and micro prudential regulation would have to be “discharged on a consistent basis across the Sterling zone.” The UK system of financial regulation has not covered itself in glory in recent years, from the LIBOR scandal, to the failure to properly investigate initial concerns about reckless banking at HBOS. The UK Government have proposed watering down the proposals of the Vickers Commission (which will ring fence retail banking protected by deposit insurance from the more risky investment trading) on issues such as leverage ratios, and have been isolated in Europe due to their attempts to weaken European legislation on financial regulation, such as their refusal to support the Capital Requirements Directive due to the desire to protect bankers’ bonuses, and their opposition to the Financial Transaction Tax. This is not a promising basis for an effective working relationship on financial sector reform, and a strong motivation for Scotland to seek its own solutions.
Flexibility in exchange rate policy is a second advantage of controlling monetary policy. There can be no better example of these advantages than Iceland, whose currency devalued 50% against the dollar and who imposed capital controls to prevent a debilitating capital flight in the wake of banking collapse (admittedly, membership of the EU would make the latter a more difficult policy option for Scotland). According to the European Commission’s 2012 Progress Report on Iceland, GDP rose by 2.6% in 2011, with unemployment down, industrial production up and the current account deficit narrowing, with the value of exports up from 2.9b EUR in 2009 to 3.8b EUR in 2011. Of course, adjustment has not been without pain for the Icelandic people. However, without the ability to devalue, adjustment in unit labour costs necessary to restore competitiveness can only come through deflation of internal demand – using the very austerity policies which have caused misery in Greece, Spain and Portugal.
Third, freedom in fiscal and macroeconomic policy. While the exact details of a “fiscal pact” remain to be determined, it would undoubtedly involve spending and borrowing limits to curb excessive deficits. We are told this is no problem as an independent Scottish Government will not behave “recklessly” in any case. This is certainly on the face of it true, given the herculean efforts of the present Government to stick within ever-decreasing block grants. But much depends on the definition of “reckless”, particularly in extraordinary economic times, given the divergences in ideology. It is not beyond the realms of the imagination to conceive of a UK Government, even more committed to austerity than the current one, demanding strict limitations on a Scottish government deficit to below 3% of GDP during a recession – even though a wiser Scottish Government may be preparing for Keynesian stimulus, with the temporarily higher deficit that involves to offset private retrenchment. We do not even have to invent a scenario. The Fiscal Treaty signed by 25 Member States at the end of 2011, committing them to keep government deficits within 3% of GDP, and thus entrenching austerity in their constitutions, was economic madness in the middle of a recession, and impossible to comply with anyway, as the repeated requests from Spain for more time to reduce its deficit have shown. A currency union could impose an uncomfortable straightjacket that we would be better off without.
Finally, policy in the direst of economic straights: hopefully never to be encountered, but preparations must be made nonetheless. Financial regulators and central banks control decision making over the recovery, bail-out or liquidation of banks, and over whether to boost the money supply and generate renewed lending through quantitative easing. Here we can only deal in hypothetical scenarios in a currency union, but they are not difficult to perceive, such as a hard-money Bank of England refusing to purchase bonds or to stimulate the money supply, in similar fashion to the European Central Bank’s actions over the past few years; or the very real-world failure to engage in imaginative forms of QE which ensure that the money actually reaches its intended targets, with overall lending continuing to decline since 2009; or a decision by the UK regulator to liquidate a bank of little importance to the English economy but of great importance to Scotland. None of these scenarios I feel are entirely outlandish. They are merely hostages to fortune, and again, we may well feel it more appropriate to seek our own.
Although monetary policy is indeed political, there is nothing necessarily partisan about such debates, in the current Scottish party set-up. The clear undertone of fear in the currency debate, from all sides, with the resultant slight glibness and lack of open-mindedness to discussing fully all the options, is disappointing, for a full examination of different scenarios, especially for the long term, is nothing to be afraid of. The point, under independence, is that we will have the freedom to choose. And that is the positive side of uncertainty.