Scotland politics

Scottish independence: What next for currency debate?

UK Chancellor George Osborne will rule out a formal currency union with an independent Scotland, government sources have told the BBC.

His position will also be backed by Labour shadow chancellor Ed Balls and Liberal Democrat Chief Secretary to the Treasury, Danny Alexander.

So what does this mean for the Scottish government's plan to keep the pound in the event of a "Yes" vote in September 2014?

Angus Armstrong, director of macroeconomic research at the National Institute of Economic and Social Research, assesses the situation.

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Next move

According to press reports, on Thursday Chancellor Osborne will rule out a formal currency union with an independent Scotland.

Given he has already said a formal currency union is "unlikely", and the Prime Minister has said it would be "extremely difficult", anything which is still ambiguous would surely be regarded as a negotiating stance.

If the press reports are correct, what would be the Scottish government's next move?

We expect the Scottish government to argue that a currency union, even if it is an informal union - "sterlingization" - is possible and the path to follow.

In our view, because of the level of debt an independent Scotland would inherit, this arrangement is likely to be unstable.

An alternative coherent option is for an independent Scotland to introduce its own currency.

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The Carney effect

The foundations for an announcement were laid in Bank of England Governor Mark Carney's speech two weeks ago.

It was no coincidence that the two examples of successful currency unions were also political unions (USA and Canada) and the unsuccessful example was not a political union (Euro zone).

The issue is whether it can be in the interests of both countries to agree to cross-border insurance programmes - such as for unemployment benefit - to make a union between sovereign states workable.

These are not small matters.

Governor Carney showed that in federal states with currency unions, such spending is usually around one quarter of GDP.

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Formal v informal

There are two remaining options - an informal currency union - dollarization, or sterlingization in this case - and re-introducing a Scottish currency.

The informal currency union, or sterlingization option, is possible, as this would not commit the Bank of England or UK tax payers to any involvement.

It would be for an independent Scotland to choose. Whether this would be wise is a very different question.

Some states have dollarized - although they tend to be either very small, such as Monaco and Liechtenstein with the euro and Swiss franc, or bigger but less developed states such as Ecuador or Guatemala, with the US dollar.

They are either tiny states with minimal debt, countries in transition from communism or countries for which this is very much a last option.

The prime example of a long lasting currency board in a modern city with a large financial centre is Hong Kong, which survives specifically because it has no debt.

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New currency

The other option is for Scotland to issue its own currency.

Indeed, there are many examples of countries of similar size and level of income (for example, Norway, Sweden, Switzerland, Denmark) which all have their own currency.

The transition from using sterling to introducing a new currency might be long and difficult, but it is possible.

What's more, at the end of the transition, an independent Scotland would have all the instruments for economic policy of a modern state.

As the Fiscal Commission made clear: "In the long run, the creation of a new Scottish currency would represent a significant increase in economic sovereignty, with interest rate and exchange rate policy being two new policy tools and adjustment mechanisms to support the Scottish economy."

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Bad debt

One bad idea which has occasionally been hinted at is the possibly that an independent Scotland reneges on paying its share of the UK debt on independence.

If an independent Scotland were to do this and then have a fast track into the EU or even NATO, what sort of precedent would this create for any other region in an indebted country around the world?

How secure would international investors and even citizens feel about lending to the government?

This does not strike us as a responsible line of argument.