Economic aspects of Scottish independence: currency

Scotland will hold its referendum on independence in September 2014. Much of the debate on independence has focused on economic arguments. A central economic issue is the currency Scotland would use if it voted for independence.

The choice of currency has wide ranging economic implications. It affects trade with other countries, fiscal policy (government spending and taxation) and monetary policy (interest rates). It also affects policies relating to financial stability.

An independent Scotland would have three main currency options: its own currency, using the Euro and continuing to use the pound as part of a “sterling zone” with the rest of the UK. This note concentrates on the last of these options as it is the Scottish Government’s preferred policy.

Such an arrangement would require an agreement to be negotiated between the government of an independent Scotland and the government of the rest of the UK. This would be likely to impose constraints on the level of government borrowing and debt an independent Scotland would be allowed to have. The Scottish Government accepts the need for such constraints but argues that these apply only to overall levels of borrowing and debt, leaving scope for fiscal policy to work through the design of individual taxes, for example. There would also need to be agreement on how to minimise risks to financial stability in a “sterling zone”.

The Conservatives, Labour and the Liberal Democrats have ruled out sharing the pound with an independent Scotland. The Scottish Government has argued that it would be in the economic interests of the rest of the UK, as well as Scotland, to agree to a sterling zone. Alex Salmond has also linked the sharing of the pound to the share of the UK national debt which an independent Scotland would take on.

If an independent Scotland did not join a currency area with the rest of the UK, its main options would be to introduce its own currency or join the Euro. A new Scottish currency would give greater scope for Scotland to pursue its own monetary or exchange rate policy. It would, however, increase the costs of trading with other countries (including the rest of the UK) and potentially expose Scotland to exchange rate fluctuations. Joining the Euro, is now probably a less attractive option than before the financial crisis. It would increase the costs of trade with the rest of the UK. If Scotland adopted the Euro, its monetary policy would be set for the Eurozone, running the risk that it would be unsuitable for Scotland’s economic needs. Based on current UK levels of government debt, it is unlikely that an independent Scotland would meet the convergence criteria for Euro membership, at least initially.