Will Scotland join the euro?

Scotland’s new currency regime options all present difficulties, but euro membership might be the most attractive choice

ECFR Alumni · Senior Policy Fellow

The eurozone has not been particularly attractive to potential new members over the past few years. Since the onset of the euro crisis in 2010, only the small Baltic states have made progress towards accession, and all of them had begun the process before the crisis hit.

This situation might change soon. If Scotland votes for independence, euro membership might be among the country’s more attractive currency choices – at least if Scotland can secede from the United Kingdom in such a way that it becomes a European Union member.

An independent Scotland would have four basic options for a new currency regime. The most obvious option for an independent state would be to introduce a new national currency – let’s say, the Scottish Pound or SP. In this scenario, on a given day, all contracts and accounts in Scotland would be converted into SP. From then on, ATMs and banks would dispense SP and the market would determine the SP’s exchange rate.

This strategy would have the advantage of allowing Scotland to determine its own monetary policy. The country would also have the ability to set national interest rates with regard to the needs of the Scottish economy and to provide emergency loans to banks in trouble.

Nobody knows whether a new Scottish central bank would be able to run a stability-oriented monetary policy.

However, the national currency option would come with a number of challenges. First, nobody knows whether a new Scottish central bank would be able to run a stability-oriented monetary policy. This would mean that the new currency would start with very little credibility. The SP would be in danger of an initial depreciation, which would lead to imported inflation. As a consequence, investors would demand higher risk premiums on Scottish bonds. Interest rates in Scotland would rise, increasing the financing costs of households, businesses, and the government.

A second option would be to negotiate a currency union with the government in London. Ideally, Scotland would make an arrangement that ensured it a say in how the Bank of England sets interest rates for the British pound, as well as access for Scottish banks to the BoE’s emergency loan facilities and a share of the BoE’s profits from issuing the British pound. This arrangement would allow Scotland continuous access to cheap finance and provide stability with regard to trade and investment.

The problem is, there are few reasons for the rest of Britain to agree to such an arrangement, especially if secession goes hand-in-hand with an ugly struggle over the share of currently outstanding gilts that will be serviced by Edinburgh and the share that will be serviced by London. In fact, just this week, the BoE’s governor Mark Carney stated that the Bank of England would be opposed to such a monetary union.

A third option for the new Scottish government would be to keep the British pound without making an agreement with the government in London, much as Panama and Ecuador use the US dollar today. The obvious advantage of this would be stability in trade and investment relations.

The downside would be that Scotland would have no say in setting interest rates and its banks would have no access to the BoE, which would make them very vulnerable to bank runs. The government would get no share of the profits from issuing currency and it would have no central bank to act as a lender-of-last-resort. This exact problem caused serious difficulties for euro crisis countries before European Central Bank President Mario Draghi’s “We will do whatever it takes” speech in 2012.

Scotland’s fourth option would be to aim for membership of the euro. This would mean that Scotland would get access for its banks to the ECB’s lending facilities, along with a (limited) say in setting interest rates and a share of the ECB’s seigniorage profits.

To introduce the euro, Scotland would not only have to be a member of the EU but would also need to have a national currency that has had a stable exchange rate against the euro for at least two years.

However, under EU rules, to introduce the euro, Scotland would not only have to be a member of the EU but would also need to have a national currency that has had a stable exchange rate against the euro for at least two years. That means that Scotland would first have to go through the introduction of a national currency. Even so, the new central bank might receive some credibility by declaring its intention to join the euro as soon as possible.

Any new currency regime for an independent Scotland will present problems, at least at first. The euro option might not be the least attractive choice – making it a real possibility that Scotland will become the twentieth euro member, after Lithuania becomes the nineteenth in January 2015.

The European Council on Foreign Relations does not take collective positions. ECFR publications only represent the views of its individual authors.

Author

ECFR Alumni · Senior Policy Fellow