This way won’t work. We agree with pro-independence economists who say introducing a new currency is the only way that Scotland can have true control over economic policy. It is a power, however, that does not come without a cost. In fact, we estimate that it would cost the average Scottish household £7,300 a year.
Our analysis shows how these effects would impact the average Scottish household earning £35,000 a year – a £7,300 annual bill: over 20% of their income.
|Hit to Finances
|Rise in cost of imports causes inflation
|Pay off British pound debts in Scottish pounds
|Interest rates increase
|Total estimated impact
There’s lots of confusion information about what currency options an independent Scotland would have. Let’s tackle some of the biggest misunderstandings.
This would be possible if both the Scottish Government and the now foreign government in London agreed to do so. It is the option that was supported by both Alex Salmond and Nicola Sturgeon prior to the 2014 referendum because it means the UK internal market – where 60% of Scottish exports end up – would remain intact. But the UK government has ruled out there being a formal currency union between an independent Scotland and the rest of the UK so it is not going to happen.
As noted above, Scotland could use the British pound “informally” though it would lose all control over monetary policy. Scotland’s large current account (Balance of Payments) deficit would mean that its sterling reserves would likely be depleted, unless strong steps were taken to remedy this and the government deficit. Markets would recognise the unsustainability of this situation. Scotland would pay a higher price to finance its borrowing, and may suffer acute pressure to move to a more sustainable situation, namely, an independent currency.
Following the introduction of a new currency, the Scottish government could seek to minimise volatility in the foreign exchange market by ‘pegging’ the Scottish pound to the British pound or Euro. This would mean that businesses trading with those territories would have more certainty about the exchange rate. Such an action requires significant foreign exchange reserves, in order to fund interventions in the market that would keep the price without a certain exchange rate of the target currency.
Trying to peg the Scottish pound to the British pound at £1 to 1 Scottish pound would be totally unsustainable. Experts estimate that the Scottish pound would be worth 20-30% less than the British pound, so huge market intervention would be required to attempt to peg the currencies at parity. The British government tried to maintain the value of a pound at too high a level in the early 90s, when it tried to stay as part of the European Exchange Rate Mechanism (ERM). It hiked interest rates from 10% to 15%, draw down on its foreign exchange reserves, but still could not maintain the pound’s value. This ended on Black Wednesday, with the pound dropping out of the ERM and devaluing sharply. A similar fate would await a Scottish pound if it sought to peg against the British pound or Euro at an unrealistic value.
It could indeed join the Euro. However, firstly it would have to have its own currency. Scotland could not go directly from using British pounds to using the Euro. That is because the exchange rate between British pounds and the Euro does not reflect what the exchange rate would be between an independent currency and the Euro. There are 4 criteria for joining the Eurozone, as outlined by Britain in a Changing Europe:
“There are four criteria that member states have to meet to do so: keeping inflation low and stable, ensuring public debt and the deficit are within EU rules, keeping interest rates low and tying the national currency to the euro for at least two years without serious issues, such as needing to devalue.”
The fiscal and trade deficits in Scotland mean that the fair value of the Scottish currency is 70-80% lower than it would be against the British pound. Scotland would therefore either suffer the same hit to the cost of living experienced under the floating exchange rate scenario above, or make radical changes to its economic situation through government austerity. It would have to demonstrate that it could keep a stable exchange rate with the Euro for at least 2 years after this.
The deficit criteria would also be challenging for Scotland. They would need it to be below 3% of GDP, whereas it has ranged between 7.7% and 10.1% in the years before Covid-19, including north sea oil revenue. The government would need to either significantly increase taxes or cut spending to hit the 3% target.
Beyond the exchange rate itself, Scotland would also face the costs of transitioning to a new currency twice, in terms of notes and ‘menu costs’ for businesses. There would also be trade friction introduced between Scotland and the rest of the UK, which is worth 3 times the value of Scotland’s trade with the EU.
Many smaller countries do indeed thrive with their own currencies. The difficulty for Scotland is that it would have to go through a painful transition to get there.
The fiscal deficit and balance of payments deficits in Scotland are both worse than they are for the UK as a whole and are also worse than all the small European nations which the SNP often compares Scotland to. These are important drivers of the value of a currency. If Scotland were to have a standalone currency, it would be judged on these factors and its fair value would be 20-30% weaker than the pound.
Scotland could change these economic fundamentals, but it would have to boost its exports, and either cut government spending or boost taxes significantly. Denmark is a different case because it regularly runs government budget surpluses, and has exported more than it imported in every year since 1990 except 1998.
The recent paper on the economy post-independence claims that Scotland can claim its population share of the UK’s gross foreign exchange reserves of $171bn. Prof Richard Murphy, an independence supporting academic, says that this is not correct. It can claim its population share of the net reserves, which is $78bn. The ‘gross reserves’ includes liabilities to other such institutions, such as foreign currency ‘forwards and swaps’.
Foreign currency reserves are crucial for the operation of an independent currency – even more so if they sought to fix the currency to British pounds or the Euro. The paper provides examples of European countries and their foreign exchange reserves as a % of GDP, with an average of 23%. Scotland’s population share of the net reserves would be around $6bn. That would be barely 3% of GDP, which is clearly far from sufficient.
The September 2022 mini-budget damaged the markets’ trust in the UK government’s ability to manage the economy and public finances; this was reflected in a weaker pound and a higher cost of borrowing. It would be critical for a new independent Scotland to demonstrate that it is a steady and responsible hand on the tiller.
The bigger issue, however, is with the fundamentals of Scotland’s economy. Scotland imports more than it exports, and its state borrows more than it spends. This is to a much greater degree than the rest of the UK. These factors, along with the smaller size of the economy, would lead its currency to be naturally weaker than the British pound, and its borrowing costs to be higher. Having a clear and sensible economic plan, robust institutions and reliable ministers would help, but could not counteract the impact of these fundamental factors. The need to set out stable public finances was a point made by the SNP’s own Sustainable Growth Commission report which noted: “Whatever it inherits financially on day one of independence it is critical that the Scottish Government moves purposefully to establish credibility and stability in the public finances as it will, for the first time, be going directly to debt markets to seek funding.”
This isn’t the case – Scotland can choose independence if it wishes.. Our conclusion is the same as many nationalist commentators: that if Scotland is to be independent, it would need its own independent currency. What Scotland needs is an open and honest debate about what the implications of currency choice post-independence would mean for Scots.
Yes, that is quite likely, and this is indeed acknowledged in the Scottish government’s recent paper:
“[Scottish pounds] would be the unit of account for Government with contracts, wages, benefits and taxes all denoted in that currency. The introduction of the Scottish pound would not prevent sterling, or other currencies, from being used. That would be open to individuals and businesses.”
However, this leads to a two-tier economy. Public sector workers, pensioners and benefits claimants will be paid in Scottish pounds. Private sector workers (especially those powerful enough to negotiate it) may still earn in British pounds. As the Scottish pound is expected to devalue by 20-30% against the British pound, it is the least well off in society, and those who keep our public services running who will lose out the most.
Even those still paid in British pounds will lose out from higher interest rates and a number of other effects. They will also still have to pay their taxes in Scottish pounds. Their British pound income would be worth a lot more in Scottish pounds, so they may therefore find themselves pushed into higher tax brackets, and paying more income tax.
The interest rates offered on government debt have to respond to the market’s willing to lend at those rates. There are several factors that mean that Scotland’s interest rates are likely to be higher than those offered by the UK. These can be thought of as ‘premiums’ which are applied to the current rate of interest.
Liquidity premium: Scotland is a smaller economy, with a smaller total debt pile than the UK. This means the market for its debt will be smaller. There will be fewer people looking to buy and sell its debt at any given moment. This means that the government will have to offer a more attractive interest rate in order to ensure that its debt can be shifted, and to keep the market moving. This is estimated to be 0.7-1.7% in a normal interest rate environment. During the past decade of very low interest rates, experts estimated it at 0.4-0.9%
Initial premium: A new currency has to rely on new and untested fiscal and monetary institutions. In the early days of such a scenario, lenders will demand a premium on debt offered by a government to cover the risk that its institutions are not well set up to maintain economic stability. This is estimated to be of the order of 1% when a new currency is launched. Over time, this initial premium should fall.
Exchange risk premium: A new Scottish pound would be expected to fall in value by 20-30% against the British pound. Even after such an event, there would be expected to be volatility in its value, whilst the currency was establishing itself, and whilst a market equilibria is found. This risk of variability in the exchange rate would be factored into an additional premium on the debt, as changes in that rate affects the value of the debt and interest paid.
If the Scottish pound depreciated by 25% against the British pound, it would be worth £0.75. If we wanted to buy a pint of milk for £1 (British) using Scottish pounds, it would now take (1/0.75 =) 1.33 Scottish pounds. So for Scottish people, a devaluation of 25% causes the cost of buying foreign goods and services to increase by 33%. A 20% devaluation increases costs by 25%, and a 30% fall would increase import prices by 43%.
When a new Scottish currency is launched, its value will be determined on the financial markets. The value of a currency is influenced by a range of factors that help central banks and investors to judge its ‘fair value’. The current account balance is the most important input, but others such as productivity and total debt also play a role.
Scotland’s economic data suggests that a Scottish pound would be worth 20-30% less than a British pound. The current account deficit is estimated to be far worse than the UK’s, as is the fiscal deficit.
Balance of Payments (Current Account) Deficit: Data from the Scottish National Accounts Programme indicates that Scotland has run a persistent onshore trade deficit over the whole period it covers (1998-2020) and the deficit has risen sharply since 2017 with an increase from 6.0 to 8.3% of GDP. The most recent calculations for the offshore account and net primary income are for 2017. Using this data yields a current account deficit of 10% of GDP in 2017, and given past historical estimates of the current balance are similar, there can be little doubt that as things stand an independent Scotland would inherit a current account deficit of at least this magnitude. The UK’s deficit has ranged between 2% and 5% in the last couple of decades.
Fiscal Deficit: Prior to the pandemic, the GERS (Government Expenditure Review Scotland) showed a deficit of 9.2-10.8% of GDP from 2016/17 to 2019/20 excluding the north sea, or 7.7-10.1% including the North Sea. There was a spike in 2020/21 (23.8% of GDP without the North Sea, 22.4% with). This year, the war in Ukraine has driven up oil and gas prices, which means that the deficit figure is likely to be lower than usual. Fundamentally, Scotland’s fiscal deficit is around 10% of GDP. In 2016-19, this was 2-3% for the UK government, although the pandemic and energy crisis have caused short terms increases. If Scotland were to take its share of UK debt with it into independence, it would have a debt to GDP ratio of around 100% which is also relatively high.
Our goal is to help people to understand how Scottish independence, and the choice Scotland makes for its currency, would impact them and why.
Our work is based on analysis by one of Scotland’s leading economists, Professor Ronald MacDonald.
Sign up to receive updates from us.