The Scottish Currency Question: A Solution


This week the Scots will vote on independence and the ghost of Bonnie Prince Charlie will ride once more… oh no! I’m not going there! Living in London and being from a country that declared independence from the crown last century I have seen up close all the cultural demons that the run-up to the Scottish vote has stirred up. It is not very pretty.

History is a funny old thing. It is something that people generally take as something resembling Holy Writ but in reality it is something that is written and rewritten over and over again. Reading the newspaper commentary in the run-up to the Scottish vote on both sides of what may soon be a border is like watching this rewriting take place before one’s eyes. Old events are summoned up and old prejudices simmer to the surface. The starting point of historical rewriting — and historians do not properly appreciate this — resembles something between historical hermeneutics and schoolyard joshing.

Anyway, let’s try to focus on the economics, shall we? I could write an eloquent post giving my little interpretation of the forthcoming election. But that would just be my opinion — the opinion of an Irish-born London resident whose ancestor appears to have been an English Catholic who fled to Ireland after he lent his support to the Jacobite cause in 1715. Another little story floating on a sea of other stories, each of them individual myths that contribute to the push and pull of the politics of this country. Better to drain the sea completely and try to catch a glimpse of the seafloor that supports it.

Now, I have already presented my interpretation of the economics of independence in a paper that I published with the Levy Institute and gave to the SNP earlier this year. For an in depth view of the economic consequences of independence I suggest consulting this paper in full. Here is a very brief summary of the paper:

  • The key problem for Scotland is that their export surplus and their government budget balance are tied to oil revenues.
  • These revenues are volatile and any substantial deterioration would lead to a fall in tax revenues and exports.
  • This means that any monetary framework must take into account the potentialities of these events otherwise it ties Scotland’s economic future to the volatility of the oil market — and to the sustainability of Scotland’s oil reserves.

And here is a brief summary of the consequences of this for various currency regimes:

  • If the Scottish keep the sterling and if oil revenues fall a government budget deficit will open up. This will leave the fiscal position of Scotland in the hands of a Westminster government jilted by Scotland’s retreat from the union. Think: Eurozone but with more nationalistic bitterness.
  • If the Scottish issue their own currency and oil revenues fall the current account will register a substantial deficit. This will put significant downward pressure on the new currency and could, in extremis, lead to a currency crisis.

Frances Coppola and others have said that Scotland should issue their own currency and then peg it to the sterling. This would simply lash the same constraints on Scotland as maintaining the currency union. They would not control their interest rate and they would be unable to run fiscal deficits without having the sufficient reserves of sterling to back them up. Coppola says (on Twitter) that this is the “least bad option”.

The reason Coppola makes the case for a peg is because she reckons that there will be very little demand for a Scottish pound. She writes:

North of the border, after independence, Scottish notes and sterling notes and coins would continue to circulate freely as competing currencies just as they currently do. But south of the border, Scottish notes would have much less value than they currently have – indeed they might be worthless everywhere except Scotland, just as the “Bristol pound” is worthless everywhere except Bristol. Only those who were doing business in Scotland or planning to travel there would want Scottish notes, and indeed as long as sterling was equally acceptable in Scotland, they might not bother with Scottish notes at all. So there would be a simply enormous exchange difference between Scottish notes and sterling.

I don’t follow this reasoning. Scotland has a far more robust macroeconomy than the UK. Here is a graph from my Levy paper showing the sectoral balances of Scotland:

Scottish Sectoral BalancesCompare that to the UK sectoral balances and you see a much more robust macroeconomy. Here are the UK sectoral balances:


The key variable that you should be looking at is the current account. Scotland has a persistent current account surplus which it achieves by exporting massive amounts of oil and gas (and food, but the oil and gas are key). The UK, meanwhile, has a persistent current account deficit.

Now, is someone seriously going to make the case to me that a country that runs export surpluses of 5-10% of GDP a year is going to have a weak currency vis-a-vis a country that runs trade deficits of 2-4% of GDP a year? That is a bizarre argument and I hope that no one would take it seriously. Importers from other countries will need massive amounts of Scots pounds to buy those exports from Scotland. That will generate huge demand for the currency. Investors will soon see this and rush into Scottish capital markets.

Coppola may, however, have a point about the short-run and I noted this in my Levy paper. In the short-run God knows how investors will react. This is where my proposal comes in. I will not lay out all the details here but only the ones relevant to this discussion.

My plan is two-phase. In the beginning Scotland will have a dual currency regime. It will maintain the sterling but at the same time issue Scots pounds at a local level. It will do this by paying part of local public sector workers’ salaries in Scots pounds and also accepting these Scots pounds in payment of local taxes (I am open to the idea of accepting these for payments of national taxes too). In addition, the Scottish government should enforce that businesses in Scotland price their goods in both currencies. Some post-nationalist slogan would do wonders in this regard — something like “Scottish prices for Scottish people”; on this front the SNP can consult what I can only guess are their legion of PR people and focus groups.

After a while, this will establish a stable exchange rate between the sterling and the Scots pound. The Scottish government can then gradually increase the amount of transactions it undertakes in Scots pounds — eventually only accepting Scots pounds for the payment of any and all taxes. As more and more of the Scottish economy transitions to the Scots pound, Scottish exporters will begin to demand Scots pounds for goods and services because they will not want to have to exchange their sterling for Scots pounds. This will generate external demand for the Scots pound and lead to the gradual creation of a sophisticated international market for the Scots pound. The Scottish government and central bank should be holding the hand of the market every step of the way as this embryo develops into a child and then gradually reaches adulthood, at which point it can be allowed go into the world alone, fully formed.

The whole plan is based around the simple notion that exchange rates should be established gradually. Scotland’s economic fundamentals — so long as oil revenues remain buoyant — allow for the hope of a highly valued currency. But it is still uncertain what would happen if they float this on the market in a potentially explosive instant. A gradual approach would allow the demand for the pound — driven at home by taxation and domestic transactions and abroad by exports — to be established over a couple of years. The peg would not allow for this as any removal of the peg would result in a once-off adjustment that would be uncertain and potentially chaotic. The dual currency approach is much more organic and gradualist.

With a floating exchange rate regime in place the Scottish economy will be well placed to deal with economic shocks. Should oil revenues begin to decline for any reason the Scots pound can fall in value to register the necessary fall in real living standards required. Again, the gradualness of the process is the key to stability. In the case of a fixed exchange rate — that is, a peg — this would possibly lead to a nasty fiscal-cum-currency crisis as foreign reserves dried up. A floating exchange rate still allows the Scottish central bank to use their reserves to prop the currency up. But by not establishing a price target it does not incentivise speculators to do what they do best: speculate (see: Black Wednesday).

Scotland could then focus on their key long-term economic problem: namely, their over-reliance on oil and gas revenues. This requires massive public investment projects in fields like green energy that will allow Scotland to continue to export large amounts of goods and services moving into the future. By formulating the correct answer to the currency question the Scots can face the real economic challenges; those that have to do with the production of salable goods and the scarcity of natural resources. By ignoring the problem and taking a haphazard, poorly thought through approach — or, what is the same: simply emulating what they think to have been ‘done before’ — they risk everything, in which case they should probably just give up the whole game.

Finally a note on the politics. Some people will say: “Sure Phil, sounds like a good plan. Well thought through and all that. But it is too new. It sounds like something that has never been tried before, no politician would go for it.” First of all, while the plan is original most of the key components have been tried before — and with great success, I have not chosen these components arbitrarily. Secondly, the SNP is about to dissolve a union that is over 300 years old. This is a massive step into an uncertain new world — one we rarely see in our rather boring and repetitive politics today — and to compare my currency plan with this is to compare apples to oranges. Or, to make the metaphor more fitting by comparing something familiar with something exotic, it is like comparing apples with Jamaican ackee fruit.

About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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23 Responses to The Scottish Currency Question: A Solution

  1. NeilW says:

    “Importers from other countries will need massive amounts of Scots pounds to buy those exports from Scotland.”

    That’s where the analysis breaks down. Oil is sold in US dollars generally, and the oil companies will only convert to Scottish pounds what it needs to pay its workers, suppliers and taxes based in that nation. The rest stays as US dollars (or whatever currency the oil actually gets sold in). Exporters, particularly multinational exporters, only change what is needed. The rest is shuffled around the multinational group via the Group Treasury function.

    Importers tend earn the money to pay for exports in their own currency, and exporters tend to spend the money they earn in their own currency on the cost side. But any saving or profit between those points can end up in anything anywhere particularly if it isn’t distributed.

    Looking at the Scottish national accounts ex oil the external budget is balanced outside the UK and in deficit to the UK. That means that the UK has to absorb Scottish government debt to be able to export all it currently exports to Scotland. I believe that is Jo Siglitz’s argument for the stability of a peg.

    Of course if the UK is ‘forced’ to buy Scottish government debt, then without that debt and a floating currency it would be similarly ‘forced’ to buy Scottish pounds to maintain the export surplus. And that tends to be what happens via the liquidity swap process within the banking system – either via the central banks or the multinational commercial banks.

    A neat idea might be to make the resource tax for oil rights a flat rate – which maintains the demand for Scottish pound regardless of market fluctuations – plus an amount that is variable based upon the decline in the value of the Scottish pound over a period. That means the oil companies’ tax for access to the resources goes up if the value of the Scottish pound goes down. The oil companies can then eliminate that tax simply by changing more US dollars into Scottish pounds voluntarily over the period of assessment.

    • Oil is priced in US dollars. It is not sold in US dollars. That is a left-wing myth.

      Looking at the Scottish national accounts ex oil the external budget is balanced outside the UK and in deficit to the UK.

      Can I haz data? I don’t think this is true.

      • Actually on the latter point you’re right. It is balanced. I just checked.

        I want a source on the point about oil exports and dollars though.

      • My understanding is that US current account deficits are sustained because oil transactions take place in USD.

        Factory states, like China, flog their goods to the US to get the USD necessary to purchase the oil.they need. The demand for USD, because it is a petro-currency, thus remains high..

      • No, Ms. Jones. That is a myth. The US sustain their CAD because of currency inflows. China buy US Treasuries and other financial instruments. It is a conscious program by the Chinese to increase their export base. Nothing to do with oil.

      • philippe101 says:

        whether or not all Scottish oil exports are sold in dollars, there is no particular reason why they would have to be sold in Scottish pounds.

    • I have re-read Neil’s point about the dollar sales of oil. He is right to point out that the multi-national oil companies resemble mini-countries in their own right and that USD reserves do not become the property of the Scottish state.

      However, this is not a feature arising from independence – this feature exists currently. So presumably, only a part of the UK’s current oil revenues currently goes to supporting the sterling exchange rate. So no difference there – Scotland’s oil position post independence would be no different pre-independence (or without independence) except that it will retain the tax revenues levied on oil sales/profits..

      The real issue is whether London currently subsidises Scotland and, if so, whether an independent Scotland can make good this subsidy. The doom mongers say it can’t. Some would say they are fatalists and defeatists to a man and woman.

      • I need evidence for this claim that Scottish oil extractors take dollars for most of their payments before I can even begin to discuss it. I find it unlikely. It sounds like a myth.

  2. Firstly, my warm regards to Phil for challenging the doom mongers. Krugman et al have been predicting the break up of the EZ for some time now, an event that has not transpired. If they are wrong about the Euro, why should we believe them about an independent Scotland?

    Secondly, addressing Neil’s point. Yes, he is right to say oil transactions take place in USD. But so what? Scotland will acquire USD reserves through its sales of oil. Some of these USD will be converted to Scottish £s, as Neil says, to pay for wages and other transactions denominated in Scottish £s.

    But also, rather than selling Scottish £s to pay for imports, Scotland could use the remaining USDs to pay for its imports. Other exports would still be denominated in Scottish £s

    So the net effect is that both the supply and demand of Scottish £s will be reduced by an equal amount. Hence there should be no downward pressure of the exchange rate. Hence Phil’s point that demand for Scottish £s (net) will be high stands.

  3. LK says:

    This was an interesting post. The economic case for Scottish independence seems to be a lot stronger than I thought it was!

    But if the oil exports falter and a trade deficit opens, does Scotland have sufficiently attractive financial and real asset markets to attract foreign exchange?

    • If oil revenues falter they will have to accept devaluation and stop consuming so many imports. They have no choice. But it is better than trying to maintain a peg with a trade deficit draining your reserves.

  4. chrisjcook says:

    John Law was on the right track 300 years ago with his proposal for a land-backed currency for Scotland. I advocate local land/location use value levies; pooling and automatic distribution to all qualifying occupiers of a land dividend of £ denominated land levy credits.

    Owner occupiers would use land levy credits to pay their own obligation: tenants could pay their rent with it, as landlords would use it for their own obligation.


    (a) Net transfer from those with above average use of land commons to those with below average use;

    (b) Potential for issuance of ‘public land loans’ – ie interest-free (but not necessarily return-free) levy credits advanced by local Treasuries to improve or develop local land.

    (c) Land-based currency which is locally fungible by definition.

    (d) Government would be dis-intermediated, but would supervise (as Monetary Authority) professional management by local service-providers-formerly-known-as-banks of credit issuance

  5. ZDENPR says:

    I second Neil’s argument about oil being priced in dollars (or another sufficiently big currency). Not that I’d knew much about oil.
    But I reason by analogy.
    In the Czech Republic, which is the country I come from, we have a trade balance surplus (but still a moderate current account deficit as most of our big companies are foreign-owned or headquartered in tax havens) and nearly all exports are priced in EUR, since our chief trading partners are on the euro and our industries are mostly subcontractors to industrial giants headquartered in Germany or elsewhere in the EU.

  6. philippe101 says:

    “Should oil revenues begin to decline for any reason the Scots pound can fall in value to register the necessary fall in real living standards required.”

    this argument would suggest that UK living standards should necessarily fall as a result of the current account deficit. Do you think that is the case?

  7. John Hobgood says:

    “this argument would suggest that UK living standards should necessarily fall as a result of the current account deficit. Do you think that is the case?”

    UK has to import quite a bit, if the CAD brings a devaluation of Sterling, the appetite for imports will become more expensive and some will have to put the item back on the shelf. If a satisfactory domestic substitute can be found, no problem. Of course, the exporter is the other side of that equation (a point raised by Neil Wilson) and exporters do like to export. If the market is large enough, they may lean on their Central Bank to intervene.

  8. JCM says:

    Crude oil is predominantly invoiced in U.S. dollars. Some exceptions exist (TOCOM settle Asian grade oil futures in yen; Chinese oil companies price domestically produced oil in dollars but settle domestic contracts in renminbi, Iran does a some bilateral trading with India, settled in rupee, the “oil-for-gold” trade via Turkey has been stopped by the U.S). But when it comes to global oil trade, the invoicing currency is practically the U.S. dollar.

    Two papers worth a read:
    Mileva & Siegfried (2007), ECB-paper: Oil Market Structure, Network Effects and the Choice of Currency for Oil Invoicing.

    Eichengreen, Chitu & Mehl (2014), ECB-paper: Network Effects, Homogenous Goods and International Currency Choice: New Evidence on Oil Markets from an Older Era.

    Quote from the latter paper: “One of the clearest signs of the US dollar’s dominant international role is its status as the all but exclusive currency used for pricing and settling transactions in global oil markets. The prices of West Texas Intermediate, Brent and Dubai crude are all expressed in dollars. The dollar is used as the unit of account for virtually all benchmark prices. NYMEX, the world’s largest oil futures market, provides quotes exclusively in dollars. In the global oil market, whether for spot, term or future contracts and irrespective of country, the dollar reigns supreme.”

    • Have given both papers a skim read. Seem to confirm that most oil transactions are quoted, invoiced and SETTLED in USD, including Brent.

      Doubtful whether settlement currency will be changed post independence even if NS oil fields could be nationalised.

  9. Pingback: A Bottom-Up Solution to the Global Democracy Crisis - New Economic PerspectivesNew Economic Perspectives

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