Speech to the Scottish Council for Development and Industry, Edinburgh

January 29, 2014

I will stick rigidly to what Thomas Carlyle described as the dismal science. Any arrangement to retain sterling in an independent Scotland would need to be negotiated between the Westminster and Scottish Parliaments…

What follows is not an assessment of whether Scotland will be overall better or worse off under independence " that is a multi-faceted judgement for the Scottish people…This is a technocratic assessment of what makes an effective currency union between independent nations…

The success of a currency area hinges on whether its features mitigate the costs of losing the flexibility that comes from an independent monetary policy…

The most obvious feature is the degree of similarity amongst members. Similar economies won’t suffer from a ”œone size fits all” monetary policy. Surprisingly, a review of major currency areas suggests that similarity is neither necessary nor sufficient for success. For example, the industrial structures of the core and periphery of the euro area are more similar than those of the constituents of Canada or the US. Yet few would argue that the euro area is the most effective currency union of the three. Conversely, the Canadian monetary union works well despite having substantially larger industrial variation than even the US.

The similarity of the industrial structure of Scotland and the rest of the UK depends on how offshore oil is allocated. With oil split on a per capita basis Scotland and the rest of the UK look about as similar as the core and periphery of the euro area; but with oil split on a geographic basis they look about as diverse as the United States. Despite any differences, the close integration of the Scottish and rest of UK economies has helped ensure that their economic performance has been very similar over a long period…

So theory notwithstanding, being similar doesn’t necessarily help and being different doesn’t necessarily hinder. This suggests we should look elsewhere for the ingredients of a successful union: to the mobility of labour, capital and goods; to institutional structures promoting financial stability; and to institutions that mutualise risks and pool fiscal resources…

Scotland and the rest of the UK are highly inte-grated. 70% of Scottish exports are destined for, and 74% of imports into Scotland come from, the rest of the UK. A word of caution applies here. There is a body of evidence that national borders can influence trade flows, even between otherwise highly integrated economies. The high degree of integration between Scotland and the rest of the UK may in part depend on their being part of the same sovereign nation…

The existing banking union between Scotland and the rest of the United Kingdom has proved durable and efficient. Its foundations include a single prudential supervisor maintaining consistent standards of resilience, a single deposit guarantee scheme backed by the central government, and a common central bank, able to act as Lender of Last Resort across the union, and also backed by the central government. These arrangements help ensure that Scotland can sustain a banking system whose collective balance sheet is substantially larger than its GDP.

The euro area has shown the dangers of not having such arrangements, as well as the difficulties of the necessary pooling of sovereignty to build them. An independent Scotland would need to consider carefully how to develop arrangements with the continuing United Kingdom that are both consistent with its sovereignty and sufficient to maintain financial stability…

It is no coincidence that effective currency unions tend to have centralised fiscal authorities whose spending is a sizeable share of GDP — averaging over a quarter of GDP for advanced countries outside the euro area. That offers scope for a significant degree of stabilisation, much of it happening automatically as slowing growth in one part of the union causes tax revenues there to fall and welfare spending to increase. Those automatic fiscal stabilisers are important within the UK — it is estimated that for every £1 that output falls the reduction in taxes and increases in transfers are together worth about 50 pence…

Fiscal stabilisation is particularly important in a currency union because it helps mitigate the loss of exchange rate flexibility. But being in a currency union can amplify fiscal stress for individual nations, limiting their ability to perform this valuable role just when it is most needed.

So it makes sense to share fiscal risks across the whole currency area. A localised shock is less likely to stretch the fiscal position in a larger more diversified currency area, especially if it shifts demand between different parts of the area. That makes a given shock to Nova Scotia less severe than the equivalent to Portugal.

The second justification for shared fiscal arrangements is that problems in one country are very likely to spill over to others. For example, the threat of default by one country may trigger a generalised crisis, particularly if the liabilities of the crisis country are held by the banking system of the broader currency area. It will be in the interests of other countries in the union to bail out a country in crisis, and that reduces the incentives for countries to run their finances prudently in the first place. At a minimum, this ”moral hazard” problem suggests the need for tight fiscal rules, to enforce prudent behaviour for all in the union, although credible sanctions for breaking those rules are hard to develop.

There is an obvious tension between using robust fiscal rules to solve this problem, and allowing national fiscal policy to act as a shock absorber. This reinforces the need for fiscal risk sharing between nations.

As the Presidents of the European Council, European Commission, Eurogroup and European Central Bank argued in their report, European monetary union, which has so far relied on fiscal rules, will not be complete until it builds mechanisms to share fiscal sovereignty…

The Scottish government has stated that in the event of independence it would seek to retain sterling as part of a formal currency union. All aspects of any such arrangement would be a matter for the Scottish and UK parliaments. If such deliberations ever were to happen, they would need to consider carefully what the economics of currency unions suggest are the necessary foundations for a durable union, particularly given the clear risks if these foundations are not in place.

Those risks have been demonstrated clearly in the euro area over recent years, with sovereign debt crises, financial fragmentation and large divergences in economic performance. The euro area is now beginning to rectify its institutional shortcomings, but further, very significant steps must be taken to expand the sharing of risks and pooling of fiscal resources. In short, a durable, successful currency union requires some ceding of national sovereignty.

It is likely that similar institutional arrangements would be necessary to support a monetary union between an independent Scotland and the rest of the UK.


Mark Carney, Governor of the Bank  of England.