The toughest question of the lot concerns currency. Scots overwhelmingly want to keep the pound. Nationalists assure them that an independent Scotland could share it with the rest of Britain. But on February 13th George Osborne, the chancellor of the exchequer, delivered a speech in Edinburgh warning them that such a sterling zone would not work and would not have his support. His view is shared by the Treasury’s top official, Sir Nicholas Macpherson, and both the Labour and Liberal Democrat parties.
A sterling zone would resemble the euro zone in some ways, with integrated monetary and banking systems but separate fiscal and political ones. This asymmetry made the euro prone to crisis, so unionists fret about the parallels. Mr Osborne fears that just as Germany had to bail out Ireland, Cyprus and Greece to save the euro, Britain might have to rescue a stricken Scotland to protect the two countries’ shared financial system.
Making matters worse, Scotland is home to two of Britain’s largest banks in Royal Bank of Scotland (RBS) and Lloyds, which is based there owing to a quirk of corporate history. If the country became independent it would have bank assets twelve times the size of its GDP.To recap: a shared currency would be problematic because it could put Britain on the hook for (1) a sovereign bailout if Scotland engages in fiscal mismanagement and (2) a Scottish bank bailout, in the event of a crisis, because Scotland cannot afford to bailout its banks without British assistance. The Economist seems to think that all currency unions are created equal. As I pointed out in a March 8th letter to the Economist, they aren’t. Some, like the euro area, lack a credible commitment not to bailout member countries. This stems, in part, from the every-member-country-has-a-seat-at-the-table structure of the euro area. Each country knows that, as the odds of default and exit increase, it can turn to the other countries for support. As a result, member countries have an incentive to engage in fiscal profligacy—the very sort of thing that necessitates a bailout. Other currency unions, like dollarized Ecuador since 2000, reflect a take-it-or-leave-it structure. With unilateral adoption, Ecuador has no claim to a bailout from the US. And, arguably, this is better for long-term prospects in Ecuador. Since Ecuadorian politicians know there is no bailout on the horizon, they are less inclined to ride off in a direction that might necessitate a bailout. Much the same can be said about the bank bailouts concern. Many countries find it difficult to credibly commit not to bailout big banks. As a result, those banks take on excessive risk. It’s a classic moral hazard problem. Being incapable of bailing out your banks is about as good a credible commitment as you can get! And, just as the lack of access to a sovereign bailout encourages fiscal prudence, a lack of access to a bank bailout encourages banks to properly account for risk. Britain’s distaste for a bilateral currency union agreement is not a concern. Indeed, Scots should rejoice! They can continue using the pound via unilateral adoption without suffering from the moral hazard problems that usually accompany monetary unions. It does mean that Scots would have to forego seigniorage—but that’s a small price to pay for a relatively stable monetary system.