Category Archives: currency

Plan B

An explanation of why Plan B must not be revealed by @TheRealMcGowan.
An explanation of why Plan B cannot be stated by @TheRealMcGowan.
I had actually decided not to write anything about the currency Plan B because I've discussed this topic at length in various posts over the past two years, but it's probably a good time to summarise them.

First of all, the reason why there's no Plan B in the White Paper and why Alex Salmond didn't want to reveal a Plan B in the TV debate is because the three principles of getting the best deal, providing maximum clarity and refusing pre-negotiation are in direct conflict:

  1. If we want to get the best deal for Scotland and provide maximum clarity to the voters, we'll have to pre-negotiate important questions such as which currency to use.
  2. If we want to provide maximum clarity and accept the veto on pre-negotiations, we'll have to give away out negotiation strategy and accept the risk that we might not get the best deal for Scotland.
  3. If we want to get the best deal for Scotland and accept London's veto on pre-negotiations, we have to be cagey about our negotiation strategy, thereby sacrificing a certain amount of clarity.

Given this trilemma, it's understandable the Scottish Government has chosen the third option. They can't force London to pre-negotiate anything, even if it would clearly be best for the voters, and of course they can't accept not getting the best deal for Scotland.

Basically, Salmond should have told Darling the following: "Of course I have a Plan B in my drawer. And a Plan C. And a Plan D. I wouldn’t be doing my job if I didn’t. However, if I revealed my alternative plans, I would effectively reveal my negotiation strategy, and that would inevitably lead to a worse deal for Scotland. I want the best deal for Scotland, so I can’t do that. Do you not want Scotland to get the best possible deal, Alastair?"

On top of this, there are extremely good reasons for believing that Plan B will never be needed because Plan A (a formal currency union) is actually in Westminster's own interest:

[The Westminster politicians are] shooting themselves in the foot if they [veto Plan A], because there’s good reason to believe that a formal currency union will benefit the rUK more than Scotland because it’s good for currencies to be anchored in natural resources (such as oil) and exports (such as whisky) rather than being dependent mainly on volatile financial services.

Westminster vetoed a currency union to achieve a No vote, not because it's in the rUK's political and economic interest (which it isn't):

It seems George Osborne was thinking that if he ruled out a currency union, voters would naturally vote No to independence. I’m not sure it has occurred to him that we might vote Yes in spite of his speech (or even because of it). [...] By ignoring [other] options and by failing to explain why rUK politicians would opt for a solution that might harm rUK businesses, he shows that his sole purpose is scaremongering. He didn’t make this speech to provide visibility for rUK businesses (which would have been prudent), but to bully Scottish voters into voting No.

Even if Plan A really was vetoed by the rUK, Scotland would definitely be using the pound anyway:

Using the pound informally would be possible, but it’s an option that is normally used by rather small countries, and I can’t see it being a sensible long-term option for Scotland (although it might be a good idea for a transitional period) [...]

[A] Scottish currency linked to the pound sterling isn’t scary at all. In fact, that’s exactly what’s already happening at the moment when the Bank of Scotland, the Royal Bank of Scotland and Clydesdale Bank issue their own banknotes. They basically have to store one pound from the Bank of England every time they issue one pound, and that’s exactly how a currency board (which is the technical name for a linked currency) would work.

To put it simply, the National Bank of Scotland will put one pound sterling into its vaults (or more likely, into an electronic account) for each Scottish pound it issues. In that way, a Scottish pound is exactly as safe as an rUK pound because the National Bank of Scotland has the means to replace the one with the other if needed.

Furthermore, if a currency union isn't agreed on, Scotland will receive a lot of assets to implement one of the solutions above:

Let’s have a wee look at the BoE’s Annual Report from 2013. On page 99 it states that the total assets are worth £58,022m (58 billion pounds), and the bank has put exactly the same amount into circulation as banknotes. This means that Scotland’s 8.3% population share last year was worth £4816m. [...]

The amounts mentioned above don’t include the UK’s currency reserves (PDF), which belong to the Treasury (although they’re administered by the BoE). In August 2013 the gross currency reserves (including gold and all that) were worth $103,418m, and the net reserves had a value of $44,862m. I’m not an economist, but I presume it’s the latter that are of interest to us here. Scotland would in other words be due currency reserves (including gold) worth $3724m (or roughly £2232m).

Of course, it would hardly be great news for the stability of the Pound Sterling to lose such a great parts of the assets underpinning it from one day to the next, which is why it’s very likely the rUK politicians will start begging Scotland to accept a formal currency union soon after a Yes vote.

Finally, joining the Euro isn't a possibility at the moment (even if we wanted to), and there's a simple way to stay out of it so long as we want:

[The] main issues are likely to be the national debt (unless the rUK decide to keep all of it in order to safeguard their permanent membership of the UN’s Security Council) and the need to have been a member of ERM-II for at least two years. It seems unlikely Scotland would be able to introduce the euro before 2023, even if it became a political priority.

Of course, if Scotland decides not to introduce the euro, staying out of ERM-II is all it takes. This is what Sweden and many of the newer EU members are doing at the moment.

It's therefore understandable why Salmond didn't want to talk about a plan B, and it's also clear that an independent Scotland will be using the Pound for the foreseeable future.

Can we now talk about something which actually matters to most voters?

Dividing up the Bank of England like a CD collection

The Bank of England is avilable to rent...
The Bank of England is avilable to rent..., a photo by aminorjourney on Flickr.
During his brief visit to Edinburgh, George Osborne said that the pound is not a CD collection that can be divided up.

It was a bit misleading to talk about the pound when what he really meant was the Bank of England -- what people commonly refer to as the pound is just the name of the currency it issues.

But why exactly can't we divide up the Bank of England like a CD collection?

Let's have a wee look at the BoE's Annual Report from 2013 (PDF). On page 99 it states that the total assets are worth £58,022m (58 billion pounds), and the bank has put exactly the same amount into circulation as banknotes. This means that Scotland's 8.3% population share last year was worth £4816m.

Now, obviously we can't magically turn £4816m worth of banknotes into Scottish ones, so I guess what would happen is that the BoE would withdraw this amount of money from circulation and transfer the corresponding assets to a brand new Central Bank of Scotland, which would then be able to issue a corresponding amount of Pound Scots.

The amounts mentioned above don't include the UK's currency reserves (PDF), which belong to the Treasury (although they're administered by the BoE). In August 2013 the gross currency reserves (including gold and all that) were worth $103,418m, and the net reserves had a value of $44,862m. I'm not an economist, but I presume it's the latter that are of interest to us here. Scotland would in other words be due currency reserves (including gold) worth $3724m (or roughly £2232m).

Of course, it would hardly be great news for the stability of the Pound Sterling to lose such a great parts of the assets underpinning it from one day to the next, which is why it's very likely the rUK politicians will start begging Scotland to accept a formal currency union soon after a Yes vote.

If the rUK politicians veto both a currency union and an asset transfer of Scotland's share of the Bank of England's assets and the currency reserves, then Scotland will definitely be entitled to refuse to accept any liabilities (in other words, Scotland will start out life as an independent country without a national debt).

What George Osborne didn’t talk about

Chancellor visits Ealing Studios
Chancellor visits Ealing Studios, a photo by HM Treasury on Flickr.
I had expected George Osborne's speech today to rule out a currency union and then discuss why a free-floating Scottish currency wouldn't work either (I think it would, but that's obviously not something he'd admit).

Curiously, however, both his speech and the paper the Treasury released at the same time (PDF) practically ignore an independent Scotland's alternatives to a currency union, and instead focus on comparing a currency union with the status quo (see for instance the graphs on page 34 in the Treasury's paper).

The Chancellor also looked rather uncomfortable when the BBC asked him how much rUK businesses would pay extra because of his refusal to contemplate a currency union:

It seems George Osborne was thinking that if he ruled out a currency union, voters would naturally vote No to independence. I'm not sure it has occurred to him that we might vote Yes in spite of his speech (or even because of it).

As I pointed out yesterday, a currency union is likely to benefit the rUK more than Scotland, so it's still very likely Westminster will climb down after a Yes vote and agree to a currency union after all.

However, even without a currency union, it's by far most likely that an independent Scotland will be using the pound. We might either simply use the rUK pound without an agreement, or we might issue Scottish pounds that are linked in a so-called currency board to the rUK pound. I believe the latter option is much more likely (see yesterday's blog post for more details), and the average voter really won't care so long as the pound in their pocket is worth the same as before.

In fact, most Scots will probably prefer having a Scottish pound linked to the rUK pound, because it means we'll have Scottish banknotes and coins, and we're used to this type of arrangement already. In reality, it would just mean that Scottish notes would be issued by the National Bank of Scotland rather than three commercial banks, which surely wouldn't be a bad thing.

By ignoring these options and by failing to explain why rUK politicians would opt for a solution that might harm rUK businesses, he shows that his sole purpose is scaremongering. He didn't make this speech to provide visibility for rUK businesses (which would have been prudent), but to bully Scottish voters into voting No.

To share or not to share a currency

woc813 Great British enamelled coin cufflinks
woc813 Great British enamelled coin cufflinks, a photo by wowcoin on Flickr.
Everybody is expecting the Unionist parties to state tomorrow that they will never accept a currency union with an independent Scotland.

They're shooting themselves in the foot if they do, because there's good reason to believe that a formal currency union will benefit the rUK more than Scotland because it's good for currencies to be anchored in natural resources (such as oil) and exports (such as whisky) rather than being dependent mainly on volatile financial services.

However, if they really want to cut off their nose to spite their face, there's nothing an independent Scotland can do to save them from themselves, and it's probably prudent to come up with a plan B.

Economists seem to talk mainly about three options: (1) A formal currency union (pound or euro); (2) using another currency without a currency union; and (3) creating a separate currency.

Nobody wants to introduce the euro just now (and even if we wanted to, one of the necessary preconditions is to have a separate currency that can be linked loosely to the euro), and if Westminster vetoes a sterling currency union, that means (1) is out of the picture.

Using the pound informally would be possible, but it's an option that is normally used by rather small countries, and I can't see it being a sensible long-term option for Scotland (although it might be a good idea for a transitional period), so that rules out (2), too.

Creating a separate Scottish currency sounds scary to many voters, but it actually isn't. What's important to understand here is that currencies can be either free-floating or linked to another currency, and those two options are as different as night and day.

A free-floating Scottish currency would indeed be a bit scary, especially at first until Scotland has had time to build up a relationship with the financial markets.

On the other hand, a Scottish currency linked to the pound sterling isn't scary at all. In fact, that's exactly what's already happening at the moment when the Bank of Scotland, the Royal Bank of Scotland and Clydesdale Bank issue their own banknotes. They basically have to store one pound from the Bank of England every time they issue one pound, and that's exactly how a currency board (which is the technical name for a linked currency) would work.

To put it simply, the National Bank of Scotland will put one pound sterling into its vaults (or more likely, into an electronic account) for each Scottish pound it issues. In that way, a Scottish pound is exactly as safe as an rUK pound because the National Bank of Scotland has the means to replace the one with the other if needed.

A currency board would bring many advantages. The person on the street would think of the Scottish pound as a normal pound, just looking different (exactly like today, except that it'd involve coins as well as notes). However, if the rUK economy collapsed at some point, or if the euro suddenly started to look attractive again, it would be easy to break the link and do something else, either floating the currency freely or replacing it with a link to the euro.

Most people will not really care whether we're in a formal currency union or using a Scottish pound linked 1-to-1 to the rUK pound, so if Westminster tomorrow rules out a currency union, it's obvious what the Yes campaign's plan B will be.

Scotland and the Euro Convergence Criteria

Scottish euro coin
Scottish euro coin, a photo by viralbus on Flickr.
At the moment, most people seem to think that an independent Scotland should either stay in a monetary union with England, Wales and Northern Ireland or introduce its own currency.

However, very occasionally somebody suggests Scotland should adopt the euro (and of course, Better Together's ubiquitous scaremongers love to pretend Scotland will be forced to join the Eurozone immediately).

It's therefore perhaps worthwhile to examine briefly whether Scotland would actually be allowed to join. To introduce the euro, a country needs to fulfil the convergence criteria:

  • The inflation should be less than 2.5% (the exact figure varies from year to year -- it's based on the inflation figures of the EU member states). The figure for the UK is currently 2.6%, but there's no reason to assume this would be the same for Scotland -- it could be either higher or lower. I don't think we can determine this at the moment; it's possible Scotland will tick this box, but it's quite likely it won't.
  • The budget deficit should be less than 3% of GDP. The UK is currently running a deficit of 6.3%, and although Scotland's finances are better than the UK's, it would require exceptionally high oil prices to push the deficit under 3%. It's probably safe to assume Scotland would need a few years to bring the deficit under control.
  • The debt-to-GDP ratio should be under 60% or falling. The UK's ratio is 90% and rising, so if Scotland inherits its population share of the debt, this criterion will be very hard to fulfil. On the other hand, if the rest of the UK decide to keep all assets and liabilities, Scotland will have a ratio of 0%, so it'd pass this test with flying colours.
  • The country should have been a member of ERM-II (the exchange rate mechanism) for two years. This means that the country needs to have had its own currency for at least two years (using the Pound Sterling doesn't count), and it needs to have been linked loosely to the euro. If we assume that an independent Scotland would continue to use the pound for at least five years after independence day before creating its own currency, the earliest this criterion can be fulfilled is 2023.
  • Finally, the interest rate should be no higher than 4.81%. The figure for the UK currently is 1.62%, so it's likely Scotland's would be much lower than the threshold, too.

To conclude, the main issues are likely to be the national debt (unless the rUK decide to keep all of it in order to safeguard their permanent membership of the UN's Security Council) and the need to have been a member of ERM-II for at least two years. It seems unlikely Scotland would be able to introduce the euro before 2023, even if it became a political priority.

Of course, if Scotland decides not to introduce the euro, staying out of ERM-II is all it takes. This is what Sweden and many of the newer EU members are doing at the moment.

Will Scotland have to join the euro?



Scottish euro coin
Originally uploaded by viralbus

The unionists seem to be in a tizzy about the prospect that Scotland will be forced to join the euro, so let's have a rational look at the most likely scenarios.

To start with, it's entirely possible (perhaps even likely) that Scotland will be allowed to inherit the UK's opt-out. In that case, Scotland will have a formal right to remain outwith the euro indefinitely.

However, what happens if Scotland has to let go of the opt-out as part of the renegotiation of the membership terms? It's not like Scotland would have to introduce the euro at once. Before any member state can introduce the euro, the convergence criteria have to be fulfilled:

  1. Inflation rates: No more than 1.5 percentage points higher than the average of the three best performing member states of the EU.
  2. Government finance:
    1. Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
    2. Government debt:The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
  3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for two consecutive years and should not have devalued its currency during the period.
  4. Long-term interest rates: The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.

Currently the UK doesn't pass any of the tests apart from the last one, and as far as I can tell, the same would apply to Scotland at the moment. Therefore, Scotland wouldn't be allowed to join the euro at first, even if the people of Scotland so desired.

It is of course possible (and probably also desirable) that Scotland will fulfil (1) and (2) in the longer term, but criterion (3) requires a deliberate step that Scotland can decide not to take.

This is how the Swedes have managed not to join the euro -- they're technically obliged to join the euro, but they have chosen not to join ERM II, which means that they cannot join. Scotland can do the same, even if it's against the spirit of the treaties.

Finally, by the time the Scottish economy qualifies to join the euro, the European Union and the euro might have changed beyond recognition, and it is entirely possible that there will be a strong desire to join the euro by then.

It's definitely not anything to worry about at this stage.