Scotland’s currency options
One of the controversial topics in the debates of Scottish independence is the currency question. The other day, the Financial Times asked several economists to consider four options available to an independent Scotland: a currency union with the UK, sterlingisation (which would be the continued use of the pound sterling but without backing of the Bank of England), establishing a new Scottish currency, and joining the euro. Not surprisingly, opinions were divided.
However, strictly speaking, the choice is not limited to these four options. Besides, there are others which deserve a closer look as well in this context.
In general, currency regimes differ by
the number of participants. Arrangements may be multilateral (such as the European currency union), bilateral (like the agreement of two countries to accept one another’s currency as legal tender. Think of the Belgian francs which were legal tender inside Luxembourg, as were Luxembourg francs in Belgium, before the introduction of the euro) or unilateral as under sterlingisation or under the current Swiss franc cap vis-à-vis the euro.
the degree of institutionalisation ranging from a managed float over various forms of currency pegs (with or without rule-bound or discretionary parity changes) to a currency board and a fully-fledged currency union.
the currencies involved. Arrangements may refer to an individual currency such as the US dollar or the British pound or to a currency basket like the Special Drawing Rights (SDR).
the degree of flexibility determining the range and frequency of changes allowed within existing arrangements. (Examples are the bands in the European Monetary System (EMS) which started with +/-2.25% in 1979 and ended up at +/-15% in August 1993.)
the criteria on which occasional changes are based.These include economic indicators such as relative prices or current-account data, foreign exchange reserves or market prices.
These are the most common currency regimes:
Free float This is a regime where a currency’s exchange rate is allowed to fluctuate without government or central bank interference.
Free floats are rarely observed in practice as even if authorities abstain from buying and selling their currency in the market they may exert an indirect influence by choosing appropriate economic strategies, signaling their preferences in one way or the other or bluntly trying to talk the currency up or down.
Managed float In principle, under a managed float exchange rates are determined by supply and demand in the foreign exchange markets, but governments and central banks intervene sporadically or systematically for different reasons.
Although exchange-rate volatility is widely regarded as a problem for trade and economic development most countries’ currencies are floating, including the US dollar, the Japanese yen, the British pound and the euro.
Unilateral peg Under a unilateral peg countries fix the parity of their currency vis-à-vis a major currency or a basket of currencies.
The chosen currency is typically the leading reserve currency in a region or worldwide and/or the invoice currency of the main trading partners. For Scotland, fixing the parity of a newly established currency to the British pound would be one option, other candidates could be, for example, the US dollar or the euro, or a basket of currencies of trading partners.
Crawling peg A crawling peg is a fixed-exchange rate system which allows for regular parity adjustments.
Countries which temporarily adopted a crawling peg include Poland (1991-2000) and Hungary (until 2001). According to the IMF, in October 2013 only two countries (Nicaragua and Botswana) had adopted a crawling peg, 15 had a crawl-like arrangement. (Note that the IMF classification of regimes slightly differs from the one chosen here.)
Unilateral currency substitution Under this regime countries adopt a foreign currency in parallel to, or instead of, their domestic currency.
Sterlingisation is one example. Another is dollarisation with the US dollar as substitute.
Multilateral systems of fixed but adjustable exchange rates Countries formally agree to fix the exchange rates of their currencies either vis-à-vis one another or a third currency.
Examples are the Bretton Woods System and the European Monetary System, but also the franc zone. Adjustments usually take place as reaction to currency crises. There is an element of flexibility through fluctuation margins or bands around the parities.
Currency board A currency board goes beyond a mere fixing of the exchange rate. It is a constitutional guarantee of a currency´s foreign value which comprises explicit restrictions on the government´s ability to print money. Currency can be issued only in exchange for the foreign currency against which its rate had been fixed. The advantage of such a system is credibility. The disadvantage is that monetary policy is determined in the country of the reserve currency and the authorities lose the means to shield the economy from shocks.They cannot raise interest rates to defend the value of their currency or to fight inflation or act as a lender of last resort in the local currency. If there is a bank run, banks cannot turn to the central bank. However, given the system’s high credibility crises may occur less frequent and be less severe.
Currency boards exist in countries as diverse as Argentina, Hong Kong, Latvia and Estonia. To mention is the particular success of Hong Kong in withstanding speculative attacks on the HK dollar during various economic shocks and political crises such as the 1987 stock market crash, the Tiananmen event in Mainland China in 1989, the Gulf War in 1990, the speculative attack after the Mexican currency crisis of 1995 and the Asian financial crisis of 1997/98.
Currency union A currency union is a form of currency substitution where all parties agree on the arrangement and adopt a common currency.
As under a currency board, this implies complete surrender of the monetary authorities’ control over domestic monetary policy. In contrast to a currency board a currency union has no quasi-automatic, built-in credibility as the eurocrisis demonstrates.
As the list shows, an independent Scotland would have more options than most observers currently assume. As a rule, the choice for or against a particular regime is between flexibility and commitment with success or failure depending on both the ability to swiftly react to undesirable market movements and to credibly uphold the system.
The problem is that for running smoothly most regimes would require an idea of the main determinants of short- and long-term exchange-rates in order to decide when and how to alter a course, adjust parities or change the rules. In a global environment, where exchange rates have become the game ball of all sorts of interdependent financial markets rather than the trade flows still dominating traditional views, theory fails to provide a solid framework for policy making as I wrote elsewhere. As a consequence, authorities tend to more or less helplessly react to market turbulences without a clear concept instead of steering an active and independent course.
Given these conceptual weaknesses I would generally have a preference for a currency regime which allows for a high degree of flexibility. Weighing the costs of exchange-rate volatility under floating against those which may arise at the breakdown of a system of fixed exchange rates, or the break-up of a currency union, the former seems the more desirable alternative. However, if a more institutionalised approach to limiting currency fluctuations and a stronger commitment is sought, a unilateral or bilateral approach would be preferable to a multilateral regime. My impression is that unilateral or bilateral arrangements are more solid and have a lower risk of failure than multilateral ones. Unilateral arrangements can function well over long periods of time as the example of Hong Kong demonstrates. Panama has used the US dollar for more than a century, as Joseph Stiglitz stressed. It is the big multilateral constructs of heterogeneous countries with diverging interests – the Bretton-Woods System, the European Monetary System, the European Monetary Union – which are fraught with conflicts and uncertainties and always on the brink of collapse.
With respect to an independent Scotland the transition period would be difficult no matter which currency solution would be envisaged. I agree with Frances Coppola that Scotland should have its own currency. In the beginning, a currency union with the rest of the UK could facilitate businesses’ adjustments and limit their costs of transition. But, given the heterogeneity of the two economies keeping the British pound seems no sustainable solution.
I also think that adopting the euro – unilaterally or by joining the eurozone – is no desirable alternative either. The eurozone is an unstable construct which under a resurgence of market volatility or changing political constellations may easily fall apart hurting in particular its smaller members and all those linked to it. The resulting uncertainty is the last thing a new country in transition would need to deal with.
The danger of high currency fluctuations notwithstanding in my view the flexibility of a floating exchange rate would make it easier to cope with the huge challenges of separation since it would provide policy with an additional instrument. Like Frances Coppola, I see the advantages of a currency board, but I would advise to allow for a transition period to decide the matter. The big advantage of a currency board is credibility. Its big disadvantage is loss of monetary control. In a sense, here monetary independence is traded for less dependence on the markets’ varying moods. But who knows? Maybe, in the case of Scotland, after an adjustment period the currency issue would turn out to be less dramatic than expected, the merits of a managed float would have become apparent, and the New Scotland would be spared the choice.