How Sovereign will Scotland Actually Be?

 POST REFERENDUM UPDATE

So, the Scottish independence referendum wasn't quite the nail-biter than everyone thought it might be. It was exciting for a while, but the "No" side walked away with a resounding victory (55% No, 44% Yes). However, it could turn out to be a a phyric victory for the "No" side if many of the 11th hour Constitutional reforms promised my Westminster are carried out. In effect, the UK would broadly become a much more devolved, federal-like constitutional monarchy. Stay tuned. Some of what is being bandied about could take a long time, possibly giving pause to some Scots in the "No" camps to re-think their decision.

However, one of the most interesting revelations to flow from the Referendum is actually in the minutes of this past summer's deliberations by the Bank of England's Financial Policy Committee. Central banks have become much more transparent in recent years, and this window in to the BOE's preparations for the financial uncertainty that would ensue after a "Yes" vote are particularly interesting. In short, the BOE would have flooded the UK with signifcant liquidity and strongly signalled to everyone that while a political decision had been made, there was no reason to panic since the negotiations to separate Scottish financial institutions from those in the rest of the UK would be years in the making. In other words, Keep Calm, Carry On!

Reports from central banks are usually a good cure for insomnia, but this one is worth a look (Financial Policy Committee Report, September 26, 2014).

____________


There's a little referendum taking place in Scotland on September 18 with huge implications for the future of Great Britain and the European Union. If you haven't paid attention yet, you should!

As the vote has neared, public opinion polling suggests it will be a white-knuckle affair. For a rundown of the debate over Scottish independence, you can do no better than the September 13 issue of The Economist. But what intrigues me most about this debate are the arguments over the financial arrangements that might be negotiated (or not) between a newly independent Scotland and what remains of the United Kingdom. As part of the debate, Scottish-based financial institutions like the Royal Bank of Scotland, have made it know they will likely pull up stakes and move their headquarters to London; makes sense given London's position in global finance. Yet, even more interesting is the debate over what currency the Scots will use in the event of an independence vote?



This is no small issue since there are grave implications for Scotland in terms of the very sovereignty many of them are seeking through a referendum. Establishing their own currency, say a Scottish Pound, would be costly and take some time in terms of building it's credibility amidst financial and political turmoil. Not impossible, but not easy.

The other two options being bandied about are the adoption of the British Pound or the Euro through a series of negotiations between Edinburgh and either London or Brussels. Continuing to use the British Pound through a "negotiated arrangement" with London has been the "yes" side's position in the referendum. However, Westminster has balked.

One irony in Scotland's pursuit of independence is that it may win political independence at the cost of monetary sovereignty. In policy terms, adopting the British Pound in Scotland is not unlike the drama of Ecuador adopting the U.S. Dollar in 2000; a massive restriction on policy latitude. The Federal Reserve doesn't consider Ecuador in the conduct of monetary policy. Will the Bank of England do so for an independent Scotland? The loss of monetary sovereignty is tantamount to governments tying one of their major policy arms behind its back; the other policy arm being fiscal policy. In general, countries do so as an extreme measure to bring credibility to their monetary system (Ecuador), or as part of a negotiated monetary union designed to augment efficiency and eliminate exchange rate uncertainty.

As the members of the Euro Area have been learning the hard way, monetary unions are tricky to manage. Scotland might apply for membership in the Euro Area, but there too are significant monetary policy trade offs. All 18 members of the Euro Area gave up their currencies, and independent control over monetary policy, when the adopted the Euro. It is managed out of the ECB in Frankfurt, and considers the entire Euro Area economy in its rate setting. For some insight into how restrictive membership in the Euro Area can be, Scotland's leaders would do well to call up the Greeks, many of whom in recent years have undoubtedly wished they still had their monetary sovereignty.

This will all get very interesting, and very real, if Thursday's vote is "yes."