Brad MacKay, University of Edinburgh

The University of Edinburgh’s Brad MacKay examines the potential impact that Chancellor George Osborne’s speech may have on the business community. This post was originally published by The Future of the UK and Scotland. 

Today’s announcement by the Chancellor of the Exchequer that there will not be monetary union between an independent Scotland and the rump UK (rUK) post-independence is a game changer. It comes one day after researchers, including myself, working in the ESRC programme into the Future of the United Kingdom and Scotland gave a briefing in Brussels on our research findings so far. In it Professor David Bell and I argued that the major uncertainties facing business are the EU, Corporate Taxation, Income Taxation and the Currency.

In my own research, I have so far conducted 52 in-depth interviews with business leaders in medium and large firms. The industries that we have focused on so far are energy (including oil and gas), financial services, engineering and industrial manufacturing, electronics and technology, and life sciences. In a clear majority of these interviews, business leaders have indicated that it is uncertainty around the currency that poses the most significant risk for their businesses.

So what are the implications of today’s announcement for a post-independence Scottish currency, and what does this mean in practice? Under EU rules for a country to join the Euro, they must first demonstrate that they can run their own currency and central bank within the deficit and debt restrictions placed on them by the EU before they can join the European monetary union. In other words, the Euro in the short-term is not an option for Scotland. Consequently, an independent Scotland will have to have its own currency, either pegged to the pound, which brings with it its own set of challenges, or a freely floating currency on international markets, which almost certainly would be a devalued, and more volatile currency. There is also the possibility that there could be some form of informal currency union, or sterlingization, which may have some attractions for business, but will still bring with it numerous challenges.

If the pound sterling is, or looks to be, unavailable to a post-independent Scotland, it will result in a number of businesses having to make tough decisions on whether they can continue to domicile themselves in Scotland, and the degree to which they maintain the same level of economic activity in Scotland. Why? Because for a significant number of medium and large businesses in Scotland, most of their trade in the UK, often as much as 90%, is not in Scotland, but the rUK. This makes sense when you consider that the population of Scotland is 5 million, but the population of the rUK is 58 million. Businesses will, therefore, have to consider very carefully a range of different factors driving their businesses, but primary among them will be three things: (1) how separate currency jurisdictions will impact on their ability sell products and services to their customers; (2) whether it makes recruitment and retention of high value, skilled labour more or less difficult; and (3), whether it creates or destroys shareholder value by decreasing or increasing costs and profitability. Global businesses whose customer base is also primarily global, however, may be less impacted.

Small businesses in Scotland will not be immune to the implications of having separate currencies in Scotland and the rUK either. For small businesses that do any trading in the rUK, they would have to deal in two currencies, and there would be costs and time involved in exchanging currencies, translating different prices from one currency to another and so on.  Economic theory suggests that the existence of a border can reduce trade, and some of these ‘transaction’ costs associated with dealing in different currencies and jurisdictions help to explain why.

Economic fundamentals suggest that for countries to share a currency there needs to be agreements over deficits, debts and taxation, which may not be sustainable for economies driven by different factors, as a Scottish resource-led economy, and a UK non-resource-led economy almost certainly would be. This at the very least necessitates close coordination, if not integration. The Euro crisis of recent years is evidence of this. So, far from being an act of bullying or intimidation, as Nicola Sturgeon suggests, George Osborne’s announcement is underpinned by what is increasingly becoming a position supported by economic orthodoxy. That’s not to say that if the political will exists for a monetary union one can’t be made to work, for a time. There are few examples, if any, where one has been made to work over extended periods of time, even with political will, without political integration.

Ethical considerations aside, if the Scottish government were to use this as an excuse to walk away from its share of the UK debt, the reaction from international markets would almost certainly be swift and brutal, and result in a poor credit rating for Scotland. This could then translate into uncertainty and volatility within the Scottish economy, which would in turn most likely reduce business investment in Scotland, economic growth and jobs. The UK government’s position on currency will undoubtedly be unwelcomed news for the Scottish government, but they would be unwise not to recalculate what this means for the independence project, and more importantly, for average Scots, and to build their case for independence from there.

So while the stated position of the Scottish government in their White Paper launched on November 26th 2013 is to continue to use the pound sterling, some uncertainty has existed about whether the UK government would agree to such a pledge. With the Governor of the Bank of England, Mark Carney’s recent speech in Edinburgh, where he outlined the economic difficulties of monetary union without political union, there has been uncertainty over whether the UK government would agree to such arrangements. It is now clear that this would not be the case, and it is now incumbent on the Scottish government to outline its plan B, whatever it may be. But even with a plan B, adopting a separate currency in a post-independent Scotland, our research suggests, is likely to be problematic for a significant number of Scotland’s small, medium and large businesses.

The implications are, of course, that independence may well result, at least in the short and medium term, in a drop of economic output as cross border trade is diminished, and some medium and large businesses (who while fewer in number compared to small businesses, are responsible for the largest proportion of jobs and national income in Scotland), choose to reduce their exposure to Scotland by migrating some of their activities to either the rUK or the EU. In the long-term, of course, anything is possible.

Professor Christine Bell, University of Edinburgh

Writing at the Future of the UK and Scotland blog, Christine Bell reflects on whether the Chancellor’s speech represents pre-negotiation and what that might mean for the campaign.

The UK government up until now has clearly stated that it is not going to ‘pre-negotiate’ the break up of the Union.  Yet to-day apparently the UK Chancellor George Osborne, along with support from the Labour party, is to rule out in advance a currency union.

In response the Scottish government has raised that they have a card to play: a possible refusal to take on a share of the UK’s national debt.

So what is going on?  Well it would seem a few polls are showing that support for independence may be on the rise.  As a consequence it looks as if the no campaign that had adopted a tactical posture of a relaxed ‘let Scotland decide’, is shifting towards playing hard-ball – corporate chiefs, the Head of the Bank of England and now the Chancellor and all future UK Chancellors are all being sent to Edinburgh, and the Prime Minister has instructed the rest of the UK to face north and feel loving feelings.  The Scottish government is wheeling out its best cannons in response.

There are several reasons why the new turn towards pre-negotiation is unfortunate and should be publicly resisted.

Read the rest at The Future of the UK and Scotland.

Professor John Curtice

John Curtice reviews the polls. He finds that most indicators continue to suggest that the verdict will be No and argues that although the debate will range far and wide in the coming months, the victory will ultimately go to the side that presents the most convincing economic argument. This blog was republished from LSE British Politics and Policy blog.

When the campaigning is finally over, the final decision about Scotland’s constitutional future will lie in voters’ hands, as they cast their ballots on the 18th September this year.

At the moment it looks as though their verdict will be No. Only one of the 28 Scotland-wide polls of referendum voting intentions conducted to date has put the Yes side ahead – and that poll (conducted for the SNP) was widely criticised for prefacing its questions with a couple that appeared to lead respondents in a pro-independence direction. Once those who say Don’t Know are put to one side (typically some 15% or so of respondents), then across all polls conducted in the last three months the Yes tally has averaged 39%, the No score, 61%. In truth has been pretty much the picture throughout the whole of the last year.

However, although the polls have been stable, they have also been inconsistent. One company, Panelbase, has repeatedly put support for Yes at 44% or 45% (once the Don’t Knows are left aside). In contrast, in Ipsos MORI’s polls, for example, support for independence has ranged between just 34% and 38%. Inevitably such a persistent discrepancy creates some uncertainty about exactly how far No are ahead.

Moreover, there are some signs that the publication at the end of November of the Scottish Government’s White Paper laying out is prospectus for independence may have helped increase the Yes vote by two points or so. We await the evidence of further polls to see whether this apparent boost for the nationalist cause has survived the Christmas and New Year campaigning lull.

How might the Yes side make the further, more substantial progress that they would appear to need? Almost undoubtedly only by persuading Scots that independence would make their nation more prosperous.

No other perception of what independence might bring is more closely linked to whether people say they will vote Yes or No. For example in one ICM poll, 87% of those who thought independence would be good for Scotland’s economy (and had a clear voting intention) indicated they would vote Yes. The equivalent figure amongst those who thought independence would be bad economically was just 4%.

Unfortunately for the Yes side, a majority of Scots are yet to be convinced that independence would actually bring about prosperity.  According to YouGov, just 26% are of that view, while 48% believe the country would be worse off.  TNS BMRB similarly report that only 23% think Scotland’s economy would perform better under independence, while 45% believe its performance would be worse. Even Panelbase find that only 32% think that Scotland would be financially better off as an independent country while 44% believe it would be worse off.

The debate about Scottish independence will range far and wide in the next nine months as the nation contemplates two alternative futures. But in the end it will be the debate about the economics of independence that will matter.

Dr. David Bell

In a piece originally published by the Scottish Sun on 15 January 2014, David Bell discusses the recent UK Governemnt announcement regarding debts in response to concerns from the markets about the status of UK debt should Scotland become independent. 

The UK Government has just announced that it will honour its debts. It has done so since before Charles II lost his head, so why did it need to make this announcement? Because it claims that those who lend money to the UK are asking questions about how the debt will be shared if Scotland becomes independent. So far, the UK government has refused to say what it might do after independence. But these concerns have forced it to show its hand. The UK government depends on the money markets to keep our schools open, to pay for pensions and to keep the health service running. Just now it can borrow at very low interest rates. Upset the markets and these rates would rise. The extra costs would have to be paid from higher taxes, or from cuts in public services.

Why the concern about Scottish independence? Because the UK expects that an independent Scotland would become responsible for a share of UK debt. If it was shared equally across all of the UK population, Scotland’s interest charges on the debt would be around £4bn. This is equal to double the total amount of council tax raised in Scotland. Some argue that this is the only fair way to share the debt: the SNP argues that Scotland’s share should be reduced because of the money that North Sea oil has made for the UK.

Uncertainty about the way the debt might be divided will make investors nervous. They will be less willing to lend to the UK. This would push up interest rates. To keep investors happy the UK Government has removed the uncertainty by agreeing to repay all debt issued before the independence referendum. It expects to agree with the Scottish Government that it will pay its share of the debt charges. But, if there is a Yes vote, the Scottish Government can choose not to pay.

A threat not to pay might be part of a strategy to get a good deal when the split takes place. There will certainly be a lot to argue over: the currency, Trident, energy, borders and so on. It will take some time to reach a deal.

But there is a danger in threatening not to take on a share of the debt. One of the first actions of an independent Scotland will be to go to the markets to raise cash. It will also want to keep interest charges as low as possible. For this, it will need a good credit rating. And the markets might be wary of a borrower that would not take a share of UK debt.

Dr. David Bell

In a piece originally published by the Scottish Sun on 15 January 2014, David Bell discusses the recent UK Governemnt announcement regarding debts in response to concerns from the markets about the status of UK debt should Scotland become independent. 

The UK Government has just announced that it will honour its debts. It has done so since before Charles II lost his head, so why did it need to make this announcement? Because it claims that those who lend money to the UK are asking questions about how the debt will be shared if Scotland becomes independent. So far, the UK government has refused to say what it might do after independence. But these concerns have forced it to show its hand. The UK government depends on the money markets to keep our schools open, to pay for pensions and to keep the health service running. Just now it can borrow at very low interest rates. Upset the markets and these rates would rise. The extra costs would have to be paid from higher taxes, or from cuts in public services.

Why the concern about Scottish independence? Because the UK expects that an independent Scotland would become responsible for a share of UK debt. If it was shared equally across all of the UK population, Scotland’s interest charges on the debt would be around £4bn. This is equal to double the total amount of council tax raised in Scotland. Some argue that this is the only fair way to share the debt: the SNP argues that Scotland’s share should be reduced because of the money that North Sea oil has made for the UK.

Uncertainty about the way the debt might be divided will make investors nervous. They will be less willing to lend to the UK. This would push up interest rates. To keep investors happy the UK Government has removed the uncertainty by agreeing to repay all debt issued before the independence referendum. It expects to agree with the Scottish Government that it will pay its share of the debt charges. But, if there is a Yes vote, the Scottish Government can choose not to pay.

A threat not to pay might be part of a strategy to get a good deal when the split takes place. There will certainly be a lot to argue over: the currency, Trident, energy, borders and so on. It will take some time to reach a deal.

But there is a danger in threatening not to take on a share of the debt. One of the first actions of an independent Scotland will be to go to the markets to raise cash. It will also want to keep interest charges as low as possible. For this, it will need a good credit rating. And the markets might be wary of a borrower that would not take a share of UK debt.

David Bell is Professor of Economics at the University of Stirling and an ESRC Research Fellow on the Scotland and the UK project. He specialises in labour economics and the economics of the Scottish economy.

Professor Brad MacKay and Veselina Stoyanova address the means by which businesses are attempting to navigate the debate on Scottish independence.

Approximately 300 days remain until the morning of the 18^th of September, 2014, when Scots will decide on their constitutional future. While the political debate is picking up momentum, thus far the focus has been on such issues as constitutional scenarios, debt shares, monetary policy, EU membership, fiscal performance, oil revenues, tax contributions and structure, defence arrangements and so on, but little attention has focused on business itself.  Yet, the health of the business community is fundamental to the health and prosperity of the economy, and society, as a whole. The current constitutional debate presents an opportunity to discuss, regardless of the referendum outcome, how an environment that is competitive for business and creates wealth can be created.

This is at the heart of this current study into how constitutional uncertainty is influencing business decision-making in Scotland and the United Kingdom. With notable exceptions, business leaders have been reluctant to ‘stick their heads above the parapet’ and take part in such a debate. This is understandable given that businesses have stakeholders, be they customers, board members, employees, shareholders, suppliers or governments, on both sides of the discussion. Moreover, all too frequently within the debate reason has given way to emotion and political ideology has become confused with business decision-making. And while business leaders, quite rightly, are keen to stay politically neutral – publicly at least – focusing their attention and decisions on their business interests, there is also an opportunity to outline what sort of business environment is needed in Scotland and the United Kingdom to stay competitive in a globalised world.

The uncertainties created by the constitutional debate vary across sectors. Such uncertainties might include access to markets, currency fluctuations, skilled labour, tax structures, research and development (R&D) incentives and regulatory regimes. What uncertainties influence individual businesses might depend on whether customer bases are located inside Scotland, the United Kingdom, Europe, or more broadly, the world. It might also differ depending on whether ownership structures of businesses are domestic or international, whether they have their head office in Scotland/the UK, or they are a subsidiary, whether they are a small, medium or large business, whether they operate in highly regulated or loosely regulated industries, whether their labour force is highly skilled and mobile, or whether they are in global or regional industries. While uncertainties present risks to businesses, which business must mitigate by the decisions that they take, they also present opportunities for rethinking business-level strategy.

The risks and opportunities that are a result of the uncertainties created by the constitutional debate will impact in greater and lesser degrees on individual businesses and sectors, manifesting in diverse ways. What all businesses have in common is that, whatever the result on September 18^th, businesses will take decisions based on whether the changes that will inevitably take place no-matter what the referendum outcome maintain or improve a business environment that is conducive to business growth. It is, therefore, incumbent on business leaders, policy-makers and the public to take this opportunity to have a mature debate about how to continue to foster a business environment that is competitive, wealth creating and contributes to the prosperity of all.

Brad MacKay is Professor of Strategic Management in the Business School, University of Edinburgh. Veselina Stoyanova is a PhD student at the University of Edinburgh.

Royal College of Surgeons, Nicolson Street, Edinburgh, EH8 9DW

This event, organised by the Institute of Fiscal Studies, will see the launch of the first long term fiscal projections for an independent Scotland. This new research, which is part of a project funded by the Economic and Social Research Council on the Future of the UK and Scotland, will use information on demographic trends, tax revenues and spending patterns to look at fiscal scenarios for Scotland and the UK over the next fifty years and their sensitivity of the projections to key assumptions over long-term growth, the cost of government borrowing and the level of net migration. The event will provide a clear illustration of the fiscal pressures facing an independent Scotland, how these are similar to, and different from, those facing the rest of the UK, and the options available to an independent Scotland to achieve fiscal sustainability.

Other presentations will focus on tax and spending as we aim to clarify some of the fiscal opportunities and constraints that would face Scotland were it to become independent.

This event will take place in Symposium Hall (King Khalid Building), the Royal College of Surgeons, Edinburgh. Registration will take place between 09:30 and 10:00 and the event is expected to conclude by 12:30. A sandwich lunch will follow and delegates will have the opportunity to meet the research team.

Further information and booking details can be found on the IFS website

Dr David Blanchflower

Dr David Bell

In this piece by Dr David Bell and Dr David Blanchflower (both of the University of Stirling) the authors explore the notion of underemployment and assess underemployment and unemployment rates in Scotland and the rest of the UK.

Part of the ESRC project on the Economics of Constitutional Change involves the collection of new data on the Scottish economy. This post develops this objective by describing a new measure of excess capacity (slack) in the Scottish labour market.

We have been working on measures of labour market excess capacity for some time and have focussed on the notion of underemployment.  This is a broader concept than unemployment which captures only the willingness of those who are not currently employed to supply work. The unemployment rate takes no account of the extra hours of work that some of those who are already employed would like to work. These hours are included in our more general measure of slack in the labour market.

The underemployment rate would be the same as the unemployment rate if all workers were happy with the hours they were being offered. But if they would like to work longer hours, the underemployment rate rises because there is more unfulfilled demand for extra hours (excess capacity) in the economy. If they would like to work fewer hours, the unemployment rate overstates the amount of excess capacity in the labour market. Typically older and male workers want to work fewer hours, while younger and female workers want more hours.

We have developed our measure of the underemployment rate in two previous papers, one published by the National Institute of Economic and Social Research and one by thePeterson Institute. The result is the Bell-Blanchflower underemployment index which uses individual data from the UK Labour Force Survey to modify the unemployment rate by taking account of the net change in working hours that existing employees say they would like to work.

The Bank of England published this index for the UK in its Inflation Report August 2013 (Table 3.A) and suggested that it reinforced the view that there is “a substantial margin of slack” [in the UK labour market] (Inflation Report August 2013 P30).  This matters to the Bank of England because its key duty is to control domestic inflation. Historically wage pressure was one of the major push factors behind increased inflation in the UK. But the ability to push for higher wages depends very much on the level of excess capacity in the labour market. The greater the excess capacity in the labour market, the weaker is the position of those seeking higher wages.

If Scotland were to become independent, it would likely have a central bank playing a similar role to that of the Bank of England. It would wish to assess the outlook for inflation in the Scottish economy. Clearly, the state of the labour market would be an important component of that assessment. Our argument would be that a measure of underemployment should form part of the analysis of the labour market. To determine how such an index might behave, we have used individual data from the Labour Force Survey to calculate our underemployment index for Scotland from 2001 to 2013. It is shown in Figure 1 alongside the unemployment rate and the equivalent rates for the UK as a whole. Table 1 shows the data on which Figure 1 is based. Our estimates are seasonally adjusted using the X-13ARIMA-SEATS seasonal adjustment method.

Unemployment has been taken as the traditional measure of excess capacity. Figure 1 shows that there was little difference between Scottish unemployment and underemployment rates until 2007. This was because the number of extra hours that some existing workers wished to work was almost exactly offset by the reduction in hours desired by a different group of workers. The same was true of the UK as a whole. However, since the beginning of Great Recession, more Scottish workers have expressed a wish to increase their hours, and fewer have argued for a cut in hours.  As a result, the underemployment rate has risen significantly above the unemployment rate. During 2012, the underemployment rate exceeded the unemployment rate by 1.9 per cent. Put another way, during 2012, on average, Scottish workers wanted to work a net 160 thousand extra hours per week. Their employers were unable or unwilling to hire them for these extra hours. This is equivalent to 51 thousand extra unemployed workers at the existing average Scottish workweek of 31.2 hours.  The unemployment rate on its own fails to account for this additional slack.

In Scotland and the UK as a whole, there has been a sharp upturn in underemployment since 2008. The more recent trend (from 2011Q4 to 2013Q1) shows Scotland performing relatively better in terms of underemployment compared with the UK as a whole (albeit starting from a slightly higher level at the end of 2011).  This is consistent with other labour market indicators, for example, from the Bank of Scotland. Nevertheless, over the last twelve years, there has been little significant change in the relative performance of the Scottish and UK labour markets in relation to their levels of excess capacity.

Table 1: Unemployment and Underemployment Rates in Scotland and the UK

Source: ONS Labour Force Survey Individual Data
Seasonal adjustment by the X-13ARIMA-SEATS method

This piece was originally published at The Economics of Constitutional Change blog and reprinted with the permission of the authors. 

Dr David Comerford, University of Edinburgh

In last month’s post, Dr Robert Zymek discussed an independent Scotland’s choice of currency in terms of the theory of Optimal Currency Areas (OCA). In this post, I assume that Scotland and the rest of the UK (rUK) do form an Optimal Currency Area, and argue that under these circumstances Scotland would stand to gain most from the benefits of a sterling union. But since the costs would fall most heavily on rUK, it may think twice before agreeing to enter a currency union with a new Scottish state.

The benefits arising from the OCA would come, largely, in the form of reduced trade costs (which primarily benefit the smaller party, Scotland). This sounds like a workable arrangement since, while Scotland would gain most, the rest of the UK needn’t lose (and indeed is likely to gain a little). All else equal, this is a so called pareto-improvement (a change that improves welfare for at least one party, without making anyone else worse off), relative to a situation with separate currencies.

But all else is not equal. In times of crisis, the central bank of the Sterling Zone may have to intervene to backstop the banks or the governments of one or other party to the currency union. As outlined in de Grauwe (2013): banks which borrow short and lend long, or governments who need to borrow to allow the operation of automatic stabilisers, are both vulnerable in times of crisis. Providing funding in such times should be a role of the central bank. However, the resources that are supplied in these circumstances do have to be paid for: whether as an explicit levy on the citizens of the union, or as a hidden inflation tax. The root of the current euro crisis is that the need for central bank funding is becoming obvious, but there was no ex-ante agreement in place as to who should pay for the resources that must be transferred.

At any one time, it might only be one of the parties to the union that requires help from the central bank, with that help funded by a levy across the whole union. But this would create a mismatch between who benefits and who pays. Such a mismatch would create the problem of moral hazard: if you know that you can benefit from a system and spread the cost onto other parties, you may be more inclined to behave in such a way as to need the benefit of the system, for example by running large deficits and increasing the likelihood of central bank intervention. Therefore, the agreement that accompanies any currency union would involve constraints on the policies and behaviours of its constituent states in order to minimise this problem of moral hazard.

The issue of moral hazard is a cost that can lower the benefits of a currency union. Even allowing for this though, the currency union may still have net benefits. Two symmetrical parties who wanted to create such a currency union – especially if they had learnt the lessons from the Eurozone – may still agree that a mutually beneficial arrangement was possible. Minimising moral hazard would involve giving up some autonomy. Each party could still be recognised as a sovereign state, whilst acknowledging that a formal currency union requires a great deal of pooled sovereignty (I deal with the claim that ‘constrained independence does not represent real independence’ elsewhere).

But the asymmetry between Scotland and rUK causes real problems for any proposed Sterling Union. With asymmetrical parties, not only are the benefits from the OCA unevenly split and weighted towards the smaller party, the moral hazard costs are split and weighted towards the larger party. If Scotland received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, and its citizens would eventually pay 10% of the costs of providing these resources. However, if rUK received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, but its citizens would eventually pay 90% of the costs of providing these resources. There is therefore a clear incentive for Scotland to put itself in a position where it is likely to need central bank support, whilst there is no great incentive for rUK to put itself into a similar position. The problem of moral hazard for Scotland is therefore exacerbated and rUK is likely to recognise this in evaluating the costs and benefits of a Sterling Zone.

If a Sterling Zone does provide net benefits overall, then it may be that the asymmetry between Scotland and rUK scuppers a project which could in principle be mutually beneficial. This is an example of a tragedy of the commons situation in which the incentives faced by the parties mean that a valuable resource is rationally squandered. In summary: the benefits of an Optimal Currency Area likely mainly accrue to Scotland due to asymmetry; and the higher costs of moral hazard mainly fall upon rUK – again due to asymmetry. If Scotland were to conduct a cost benefit analysis of the value of a Sterling Union then it might likely agree that it was the policy to pursue.  If the rUK were to undertake the same calculation, they are likely to reject the policy. This seems to be consistent with the campaign positions that we see.

Dr. David Comerford has recently finished his PhD in Economics at the University of Edinburgh.

Dr. Robert Zymek, University of Edinburgh

In the first of a series of monthly blogs on the independence referendum from Edinburgh University’s School of Economics, Dr. Robert Zymek weighs up the practical considerations around the currency arrangements of an independent Scotland.

The politics of Scotland’s currency arrangement pose a conundrum for advocates of independence. On the one hand, polls show overwhelming support among Scottish voters for keeping the pound. Chancellor George Osborne seized on this when, on April 23, he suggested that England, Wales and Northern Ireland could veto a currency union with a newly independent Scotland – a scenario that may deter potential Yes voters in next year’s referendum. On the other hand, retaining the pound may trap Scotland in an uneasy live-in arrangement with the rest of the UK. The No campaign has exploited this inconsistency, with Alistair Darling declaring that such a currency union would “undermine Scottish independence”. The SNP’s official response has been to argue that a formal currency union between Scotland and the rest of the UK – a so-called Sterling zone – would be in the interest of both countries if Scotland were to become independent. (See also Alex Salmond’s article in the 5 May 2013 edition of the Mail)

While the question of an independent Scotland’s choice of currency is hard to disentangle from political strategy as the referendum campaign heats up, it is clear that the eventual nature of the currency arrangement would have profound implications for the Scottish economy. In this post, I will explore the pure economic angle on this choice, conveniently leaving political and legal considerations aside.

In principle, Scotland could opt for one of three currency regimes: i) keeping the pound – unilaterally or as part of a formal currency union with the rest of the UK; ii) joining the euro; or iii) setting up its own currency. To evaluate these options, it is useful to refer to the “Theory of Optimum Currency Areas” which was developed by the Canadian economist Robert Mundell in 1961 (and which helped win him the Nobel Prize in 1999).

Mundell showed that two regions were more likely to form an Optimum Currency Area (OCA) if they had strong trade and financial linkages, and if their cycles of boom and bust coincided. The first part of the argument is straightforward: the more two countries trade with one another, the more damaging is the risk of sudden movements in the exchange rate, and the more beneficial the stability guaranteed by a common currency. The second part follows from the fact that two countries which share a currency must also share a central bank: the bigger the differences in economic conditions in different parts of the currency area, the more difficult it is for the central bank to set interest rates so as to provide economic stability for the area as whole.

How can these criteria inform Scotland’s optimal currency choice? At present, the Scottish economy is much more tightly integrated via goods trade and capital flows with the rest of the UK than with the Eurozone. At the same time, there are major economic shocks – most notably a decline in the oil price – which could put Scotland’s business cycle out of sync with both regions. The question is how likely such shocks are. The diagram below illustrates this point. If the risk of an economic shock affecting Scotland alone is low (solid circles), Scotland and the rest of the UK may represent an OCA due to their strong economic linkages, but Scotland and the Eurozone may not. If the risk of a Scotland-specific shock is high (dashed circles), it may be best for Scotland not to share a currency with either region.

Even in the latter case, Scotland may prefer to be part of a Sterling zone rather than the Eurozone. Thanks to an open border and common language, Scottish workers can easily move Southward in search of jobs, and Scottish savers are heavily invested in English banks and companies. This insures firms and workers against an isolated downturn in the Scottish economy.

Closer social and economic ties can thus serve as a substitute for synchronised business cycles in a currency area. Yet these ties are themselves affected by currency arrangements: if Scotland were to ditch the pound and join the Eurozone, new economic links with its Euro partners would likely crowd out some of the current trade and migration between Scotland and the rest of the UK. Over time, Scotland and the Eurozone could gradually evolve into an OCA, while Scotland and the rest of the UK might grow apart. Similarly, an independent Scotland issuing its own currency (which should be called the “Bawbee”, according to economist John Kay, in reference to a coin first issued by James V) may drift away economically from both the rest of the UK and the Eurozone.

Such dynamic considerations mean that the optimal currency arrangements cannot be chosen based on historical market integration and business-cycle synchronisation alone. An independent Scotland’s choice of currency should also reflect its intended place among the economies of Europe.

Next month, my colleague David Comerford will take a closer look at the constraints a hypothetical Sterling zone would impose on Scottish fiscal and prudential policy after independence.

Dr. Robert Zymek is a Lecturer in Economics at the University of Edinburgh. 

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