Some thoughts on Scottish secession from the UK
Britain faces a crisis of monumental proportions as the Scottish electorate decides whether to leave the Union and make Scotland a fully independent country for the first time since 1707 when it first entered into political union with England. This vote has all sorts of ramifications for the currency, monetary policy, fiscal policy and the banking system within the UK and Scotland. But it also has far-reaching implications for the whole of the EU. I have a few thoughts on how to frame the issue below as well as a model for how to secede if it comes to that.
For months now, it had seemed that Scotland was poised to vote “No” to secession. But a recent YouGov poll shows the “Yes” and the “No” camps in a statistical dead heat among likely voters. And so we are now forced to decide what to do, if Scotland decides to secede. We have seen numerous countries break apart in recent years, including Yugoslavia, Czechoslovakia and the Soviet Union. But this would be a first within the European Union and would therefore set a precedent for separatist forces in Belgium, Spain, Italy and elsewhere. The key issues include government assets and liabilities, currency, labor mobility, and EU accession. Let’s start with the currency.
Right now, the main sticking point seems to be the currency arrangement between Scotland and the United Kingdom after a potential secession. In the lead up to voting, the Scottish National Party have told voters that Scotland would keep the British Pound after secession irrespective of what the British want. Ostensibly, this has been done in order to maximize “Yes” votes, particularly among more conservative Scots who would feel uneasy about a new currency arrangement as well as a new government. And there are numerous examples out there of individual economies that are “dollarized” or “euroized”. The problem, however, is that the Scots’ keeping Sterling presents a host of potential problems, some of which could have catastrophic consequences.
First, there is the impossible trinity of fixed exchange rates, free capital movement and an independent monetary policy. Governments which have pursued all three simultaneously have failed in the effort. One or more of three must give. In the case of Scotland, seceding with Sterlingization i.e. trying to maintain the British Pound, effectively fixes its exchange rate. The Scots cannot have an independent monetary policy in that case. Deep imbalances would build that would eventually force the Scots into a balance of payments crisis or sovereign default.
Second, at the same time, we should expect capital flight to occur. As we have seen in the eurozone with the banking crisis there, weaker members of the currency area do not have governments which can deal with large-scale banking crises without external support. Because these governments do not control their own currency, markets recognize that they do not necessarily have the financial resources to backstop their banks, creating the pre-conditions for a run on their banks and serious capital flight. The Scottish banks, understanding this, would likely pre-empt this flight by re-domiciling back in the UK, were Scotland to secede. Lloyds and RBS have confirmed this already. But even then, the Scots would have to worry about their bank deposits because the UK government would not be liable to make good on them via a UK deposit scheme were a Scottish bank to fail. So, we would see capital flight to Britain even after the banks re-domiciled there.
The Canadian case is instructive here. The Parti Quebecois have fought a battle for the secession of Quebec from Canada for almost five decades. During that time, they have held two referenda on secession, one in 1980 and another in 1995, both of which produced “No” votes. In 1980, the “Yes” side won only 40% of the vote. But the uncertainty was still great enough that a mass exodus of business occurred. Acts of terror in Montreal’s English-speaking enclave of Westmount helped. But, let’s also remember that a second plebiscite was held fifteen years later, two years into Liberal party leader and Quebec native son Jean Chrétien’s reign as Canada’s Prime Minister. And there the vote was on a knife’s edge, with the “Yes” vote eking out a 50.4% to 49.6% victory. That tells us this issue will not go away any time soon. And so, the flow of business, especially banking, out of Montreal due to Parti Quebecois independence push, is an example of what to expect for Edinburgh going forward.
Third, if Scotland stays on the pound, Scottish citizens would essentially be making contracts in a foreign currency. Debt incurred in that currency could leave them open to a serious increase in their real debt burden were Scotland to eventually get its own currency.
EU and NATO accession
The currency issue pops up again when we think about Scotland’s membership in the European Union. Now, ostensibly, there is no reason that Scotland should be blocked from joining NATO. At the same time, however, there are many reasons why it would be blocked from joining the EU, primary among them is the currency.
New entrants to the EU are required to adopt the euro. An independent Scotland would cede monetary and fiscal sovereignty to join the EU. The EU is saying Scotland must re-apply. So, if they want to stay in the EU, the Scots would need to eventually adopt the euro.
Numerous EU officials have said that Scotland would have to re-join the EU were it to secede. Back in December 2013, European Council President Herman Van Rompuy declined to comment on a specific secession scenario, but agreed to set out “some of the principles that would apply in such a scenario.” Doing so, he said “a new independent state would, by the fact of its independence, become a third country with respect to the Union and the treaties would, from the day of its independence, not apply anymore on its territory.” He also stated that these countries could “apply to become a member of the Union”, but “this would be subject to ratification by all Member States and the Applicant State.”
Outgoing European Commission President Jose Manuel Barroso even said this past February that it would be “extremely difficult, if not impossible” for Scotland to join, ostensibly because of the precedent it sets for separatist movements like the one in Italy. Incoming EC President Jean-Claude Juncker has backed Van Rompuy and Barroso up on this matter, stating “Mr Van Rompuy and Mr Barroso have already answered the questions about EU membership. I have nothing to add.”
The interesting bit here is that Olli Rehn, European Commissioner for economic and monetary affairs, has said that joining the EU while keeping the pound “would simply not be possible” because EU membership requires countries to have access to an independent central bank.” So, by simply keeping the Pound, Scotland would be out of the EU. Given what I have already discussed about the pitfalls of Sterlingization, and given the problems we have seen for the eurozone periphery, perhaps the Scots should just stay away from the European Union altogether. If the Scots stayed out of the EU, they would need to carve out an unanimous vote treaty with the EU to maintain labour mobility. Norway, Iceland and Switzerland are good examples of what would work here.
Government assets and liabilites
Finally, there is the issue of UK government assets and liabilities, particularly the ownership of Royal Bank of Scotland and Lloyds. I am sure an arrangent can be worked out to carve up these assets. So I see this as an obstacle, but one of the least important ones.
The answer is monetary independence
What the Scots should do is a version of what the Greeks or Italians would do if they were to return to their old currencies. The goal is to minimize the downside of a new currency, which would potentially be capital flight but to move to currency sovereignty as quickly as possible.
- Plan. The Scottish government can plan for a redenomination into Scottish Pounds in secret.
- Law. “Sterlingization” would remain in place in the short-term and the British Pound would continue as the currency of physical payment. However, Scottish Pounds would become the national currency, pegged at 1 to 1. All debt under Scottish law would be redenominated into Scottish pounds at the 1 to 1 exchange rate peg. This would effectively make Scotland a dual currency regime.
- Taxes. The government would announce that henceforth it will tax exclusively in Scottish Pounds. All municipal governments would be required by law to tax in Scottish Pounds.
- Banks. Like the Argentines before them, the Scottish government would convert all British Pound bank accounts legally into Scottish Pounds. The systems would process as if it were British Pounds because of the fixed peg, but legally the money would be Scottish Pounds. This would make the Scottish economy “Sterlingized” but make the banking system redenominated into Scottish Pounds.
- Retail. Retailers, all sellers of Scottish goods, would then be forced to go into a double accounting treatment similar to what euro retailers used between 1999 and 2002 before the euro was physically printed. They would denominate all transactions in both British Pounds and Scottish Pounds – and this would be simple since the fixed exchange rate is one for one. Again, the paper money would be Sterling and each Pound would initially be worth 1 Scottish Pound. The electronic money would legally be Scottish Pound, even while the systems said British Pounds.
- Physical currency. Scottish Pounds would be printed by the newly formed central bank, the Bank of Scotland and introduced to replace British Pounds. One way to do this without disruption is to simply declare all existing Pound notes that are printed in Scotland and in circulation as legal Scottish currency, while other notes are not. The point here is that with the peg, these notes will be equivalent in value, though we can expect some discounting for the Scottish currency.
- Float. After this arrangement is in place, at some point after redenominating, without notice, the Scottish government would drop the exchange rate peg and float the Scottish Pound as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between British Pounds and Scottish Pounds and only the Scottish Pounds in circulation would be legal tender, though British pounds could be accepted.
Now, the important bit here is that the Scots want to minimize disruption in the beginning and, so, want to keep Sterling. But doing so is going to curtail national sovereignty. As a result, they will need to have top secret plans to move away from Sterling. Clearly, if these plans are found out, it could cause capital flight. So the goal is to make an actionable plan that can be implemented quickly and without a great deal of disruption and cost to citizens or retailers. For the average Scot, most of this will be seamless, though the switch from British Pounds as acceptable tender to British Pounds as foreign currency will take some getting used to. But the Scots already print money. So, doing this will be much easier to enact as a result.
The most important bit here, however the vote turns out, is that the Scottish National Party need to recognize the danger of taking on a foreign currency as legal tender and national currency and move away from doing so.