Scotland: currency options and public debt.

Armstrong, Angus ; Ebell, Monique

This paper considers which currency option would be best for an independent Scotland. We examine three currency options: being part of a sterling currency zone, adopting the euro, or having an independent currency. No currency option is the best when considered against all criteria. Therefore, making the decision requires deciding which criteria are most important. Recent events around the world, particularly in Europe, show that it is essential to consider how an independent Scotland would seek to adjust to adverse economic circumstances. In economists' terms, it is important to think through the 'off-equilibrium' adjustment paths of each of the currency options. The amount of public debt, and so the capacity for a fiscal response, is a critical determinant of these paths and therefore of the optimal currency choice. Since commitment to a currency union by an independent country can only be conditional, an independent Scotland might find it optimal to abandon the currency union in the future if the financial stability advantages to having its own currency begin to outweigh any disadvantages due to trade and transactions costs.

Keywords: currency union; monetary union; optimal currency area; debt sustainability; speculative attacks

JEL Classifications: E52; E58; F31; F33; F36; H60; H63; R113

"It is patently obvious that periodic balance of payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the international price system from fulfilling a natural role in the adjustment process."

Robert A. Mundell, A Theory of Optimal Currency Areas (1961)

Introduction

The choice of currency is integral to the economics of independence. It matters much more than simply the notes and coins in peoples' pockets. It determines how monetary policy is managed, whether there is any scope for exchange rate adjustment, the exposure to financial sector risks and even the scope for fiscal policy. In many ways, the choice of currency arrangement will determine the economic governance of an independent Scotland.

This paper considers the main currency options available to an independent Scotland. Each option offers a different trade-off between minimising exchange costs to support transactions across the border versus the scope for setting independent economic policy. The Treasury has argued that as long as Scotland is within the UK and there are fiscal transfers between regions, then it is optimal to have sterling as the single currency. The Scottish government has argued that if Scotland becomes an independent country, a sterling monetary union involving a joint governance structure of the Bank of England would be its preferred arrangement. (1) However, the Treasury has also repeatedly stated that it is unlikely to agree to such a monetary union. On this key issue the electorate is likely to be left with a stalemate.

In our view, it is not enough just to consider which currency option is most convenient for minimising the cost of transactions across the border. Recent events around the world, particularly in Europe, show that it is essential to consider how an independent Scotland would seek to adjust to adverse economic circumstances. In economists' terms, it is as important to think through the 'off-equilibrium' adjustment paths of each of the currency options. The amount of public debt, and so the capacity for a fiscal response, is critical to these paths. We argue that the amount of public debt is therefore critical to the optimal currency choice. There are enough examples of indebted countries in currency unions that endured destructive feedback loops and eventual severe recession to warrant full and thorough consideration. The welfare costs from the disorganisation which follows far outweigh any marginal effect on trade. A recent study by Laeven and Valencia (2012) shows that there have been 218 currency crises between 1970 and 2011, 65 of which coincided with sovereign debt crises. The costs of the instability are an order of magnitude larger than the gains from increased trade. (2)

Independent Scotland

The optimal choice of currency for any country depends on its economic circumstances. An independent Scotland would be fundamentally different from Scotland today. Its initial economic conditions will depend heavily on how the existing assets and liabilities and institutions of the current UK are divided between an independent Scotland and the rest of the UK. The Scottish Government's (2013b) White Paper suggests that its preferred boundary for measuring the public sector is HM Treasury's (2013) Whole Government Accounts (WGA). (3) These are based on commercial principles and represent the consolidated accounts of all audited public sector entities, meaning that inter-government claims (for example, the Bank of England's holdings of assets from quantitative easing) cancel out. It includes claims on physical assets, off-balance sheet exposures (e.g. the cost of financial sector interventions and Private Finance Initiative contracts), accruals arising from past activities (such as public sector pensions) and certain provisions and contingent liabilities. Natural resources and future revenues and expenses based on current policies are excluded.

Despite the fluidity of international borders, history offers surprisingly few precedents on how to divide up national assets and liabilities. There have been only a few cases of states seceding from a larger state that have been cordial and not involved war or the end of colonialism or communism. Two recent examples of 'friendly' separations which offer some guidance are the so-called 'velvet divorce' of Czechoslovakia in 1993 and the ultimately failed campaign for Quebec separation from Canada in 1995. In general, physical assets are divided on the basis of location, while non-physical assets and liabilities were divided on the basis of relative population size. The Vienna Convention of 1983 which sought to set out some principles for the division of debt in new states proved to be controversial and has not been ratified by any major advanced economy and so has not come into force.

While there would be many public sector assets and liabilities to be divided, three important issues to consider are the remaining North Sea oil and gas reserves, the UK public sector debt and the Bank of England. For a full discussion of the issues involved see Armstrong and Ebell (2014, forthcoming). While the onshore location of physical assets is clear, offshore assets are less certain. Most maritime experts expect that the starting point for negotiations over the oil and gas reserves will be the median line which would award approximately 90 per cent of the remaining reserves to an independent Scotland. (4) Using the Office of Budget Responsibility's (OBR) estimate of the cash value of the tax revenue from remaining reserves, Scotland's 90 per cent share would be worth around 50.4 billion [pounds sterling]. Scotland would be a large exporter of oil and gas while the UK would become a significant importer. (5)

There are a number of issues around how the UK public debt would be divided. The first is the measure of debt to be used. In 2011-12 the WGA show public sector net liabilities of 1,347 billion [pounds sterling] compared to the narrow public sector net debt (PSND) measure of 1,106 billion [pounds sterling] and gross debt or the Maastricht measure of 1,325 billion [pounds sterling]. We assume that gross debt is the basis for negotiation because it is the most common international measure and is similar in value to the WGA figures used to measure the assets. The next issue is how the debt is divided. Following the Czechoslovakia precedent we assume this is on a relative population basis, which has been acknowledged by the Scottish government. (6) According to the OBR, UK public sector debt on a gross basis in 2016/17 (when independence would take effect) is projected to be 1744 [pounds sterling] or 94 per cent of UK GDP. Allocating a population share of 8.4 per cent of the debt and the GDP which includes a geographic share of oil to Scotland yields an initial debt level of 146 billion [pounds sterling]. This implies that Scotland's debt to GDP ratio would be approximately 81 per cent, while for the continuing UK it would rise to 104 per cent. (7)

The Scottish government's (2013b) White Paper and statements from the First Minister also make it clear that sterling and the Bank of England are viewed as assets to be shared in the event of independence. (8) After all, the Bank of England is the central bank of all nations of the UK. Since the Bank of England's balance sheet is primarily financial (rather than physical), there is a reasonable claim that an independent Scotland would be entitled to a population share of its assets and liabilities. Yet the Bank's balance sheet is already consolidated in the WGA and therefore part of the 'net' asset figures referred to above. The most recent estimate of the net worth of the Bank of England is 3.35 billion [pounds sterling], of which a population share would be 280 million [pounds sterling].

However, the real issue is that sterling has a valuable reputation of being a 'hard currency' and therefore is accepted as a sound store of value. The Scottish government rightly sees this property as being extremely valuable, especially to a new state. But as with all currencies, sterling's value over the long term depends on controlling its supply, which can only be assured if the issuing state controls its finances and honours its commitment to pay its debts. Governments since Charles II have not defaulted on debt or eroded its real value through excessive and unexpected inflation. (9) This track record over such a long time period is unique. Sterling is perceived as being a sound store of value, which lowers the cost of borrowing. Yet this property is inalienable to the UK government; it is part of its history. The UK government may choose to share sterling's reputational value by extending the powers of the Bank of England, but it cannot divide and transfer part of its reputation to another government like a physical asset, even if it were inclined to do so. (10)

Currency options

The main currency options for an independent Scotland are summarised in table 1. Scotland could, in theory, choose to use any currency as legal tender, but there are probably three realistic options: to introduce a new currency, to use sterling or to use the euro. Each of these options has at least two variants shown in the second column in the table. For example, Scotland could reintroduce its own currency, and the policy arrangement could either be a floating or fixed/pegged exchange rate. Similarly, there are two broad categories of currency unions; an informal currency union and a monetary union (sometimes called a formal currency union). The Scottish government could choose to use sterling or the euro in an informal currency union. This would not necessarily require the agreement of the authority issuing the currency. For example, Montenegro uses the euro without the agreement of the European Union. A fundamentally different currency arrangement is a monetary union where the central bank is shared between two or more governments, and operates on behalf of its member regions. The obvious example is the European Union's supranational central bank, the European Central Bank, which consists of representatives of all seventeen members of the eurozone who must act in the interests of all members rather than the nations they represent. If the UK government agreed to share control of the Bank of England, and have two independent governments indemnify it for any losses, this would become a Sterling Monetary Union. This would require the endorsement and legislation of the continuing UK government as the Bank of England is constituted under Acts of the UK Parliament.

Scots pound option

If Scotland were to introduce its own currency, the obvious disadvantage is that there would be transaction costs for trading, investing, moving and spending across the border. However, the evidence from introducing the euro suggests that the impact on trade and welfare is perhaps less than expected. Dell'Ariccia (1999) shows that the elimination of exchange rate volatility between fifteen EU states and Switzerland would have increased bilateral trade by 12 per cent. Using a different methodology, Santos Silva and Tenreyro (2010) find that adopting the euro did not have a significant effect on trade compared to other EU and EEA countries which did not. In a more direct test, Thorn and Walsh (2002) consider the case of Ireland ending the Irish pound link to sterling in 1979. They conclude that ending the link "did not slow the growth of Irish trade with Britain to any significant effect". (11) Even a casual look at other European countries which retain their own currency (e.g. Norway, Sweden, Denmark and Switzerland) does not show obvious disadvantages.

The most important advantage of having a Scottish currency is the added element of flexibility. A Scottish currency would bring the greatest degree of autonomy over economic policy and so is perhaps the most consistent with the notion of economic independence. The Fiscal Commission Working Group (FCWG) states, "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". (12) However, this is a double-edged sword; a newly independent country with no track record and substantial debt would need to earn the credibility that the greater autonomy and flexibility will be used appropriately. (13)

The Scottish government would also have full responsibility for financial stability. Central banks which issue their own currency can play a special role in supporting financial stability. They have a unique feature in that, unlike private firms, they need not default. If the Central Bank of Scotland (CBoS) does not tie the value of its currency to an asset, such as gold or another currency such as the euro or sterling, then it has no commitment to exchange its currency for any other asset. (14) The central bank's only liability is a promise to repay the bearer, which could be honoured by repaying creditors with some newly created money. The only limit is that this increase in money does not violate the inflation target. In periods of financial distress when private agents want to hoard the safest asset, central banks' supply of liquidity provides an important safety valve. (15)

Sterling currency zone

The attractions of sterling for an independent Scotland are familiarity, no risk of disruption to existing contracts and that there would continue to be no transaction costs for exchanges between Scotland and the rest of the UK. Having prices of goods and services in sterling on both sides of the border may promote competition, although looking at the performance of European states which joined the euro compared to those which retain their own currency, this is likely to be modest. Although these are clear advantages over both the euro and Scots pound options, it would be a mistake to confuse familiarity with continuity; the structure of the economies of an independent Scotland and continuing UK would be very different compared with their structure within the Union. (16)

There have been many different types of currency unions. (17) At one extreme the Scottish government could simply use sterling as its legal tender without needing any formal permission from the UK government. This would be a sterling equivalent to 'dollarisation' in Panama for example, or even Montenegro's unilateral decision to use the euro. A more plausible sterling currency zone design is that Scotland could form a currency board arrangement where all sterling notes issued by the Scottish central bank are backed by sterling deposits at the Bank of England. This would be similar to the currency arrangements in the Crown Dependencies (Isle of Man, Jersey and Channel Islands). However, Scotland would not have influence on either conventional or unconventional monetary policy (such as the funding for lending scheme or the asset purchase scheme).

Within an informal currency union an important issue is the extent to which the Bank of England would provide standard lender of last resort facilities to financial institutions headquartered in Scotland. Several UK subsidiaries of foreign banks are members of the Sterling Monetary Framework and therefore have access to lender of last resort facilities at the Bank of England. There is no reason why Scottish banks' subsidiaries in the rest of the UK, which meet the qualifying prerequisites, would be excluded from the Framework. However, there is a substantive difference between providing sterling liquidity to institutions operating in the UK and providing open support facilities to institutions in what would become an offshore sterling market.

A sterling monetary union would involve sharing the ownership of the central bank for the sterling currency zone. The Fiscal Commission Working Group (2013b) suggests the creation of a supranational central bank with the Bank of England and Central Bank of Scotland as members or through a joint ownership and governance structure of the Bank of England based on population. However, the large difference in size between Scotland and the rest of the UK is a critical limitation. Based on a fair division of voting rights, with the rest of the UK ten times bigger (by population) than an independent Scotland, it is unclear how this would result in real shared responsibility. Neither is it clear whether the one-sided monetary union would be very different from the informal currency union. For example, it has been suggested that perhaps there could be a Scotland representative on the Monetary Policy Committee. But it is unclear how a single vote could ever exert any more influence than at the margin. (18)

A shared central bank also raises the prospect of moral hazard. The taxpayers of the UK would now have an exposure to an independent Scotland and the taxpayers in an independent Scotland would have an exposure to events in the UK. Whenever agents are not directly responsible for the consequences of their actions there is the possibility of moral hazard. However, the only realistic scenario is that the rest of the UK may be required to bail out an independent Scotland (rather than vice versa). To avoid any prospect of this outcome, the UK government would require strict and binding limits on Scotland's fiscal independence. Europe offers an important lesson on enforcing non bail-out conditions on governments in the midst of a fiscal crisis. Once the full implications of allowing a default were understood the infamous no bail-out Clause 125 of the Maastricht Treaty was soon ignored.

In these circumstances, whether a monetary union is effective depends on whether the UK could impose binding constraints on an independent Scotland to minimise moral hazard and its risk exposure. Yet the idea that one country can impose constraints which bind in all circumstances on another country contradicts the idea of independence. The Scottish government's White Paper (2013) is very clear that, as an independent nation the choice of currency arrangement in the future must always be open to the people of Scotland. This must always be the case in a democratic nation. Yet it also makes clear to the rest of the UK that any monetary union would only last as long as it remains in the interests of Scotland. This contradicts the notion of imposing binding constraints in all circumstances.

Flandreau (2006) makes a similar point in his assessment of the Austro-Hungarian Monetary Union; the common central bank delivers a range of services that are valuable to both parts, but not equally. If power is proportional to size, the small country has very little control over common decisions. It is bound by the discipline of the union without being able to influence decision-making in a way that would address its own specific interests. Cooperation (that is, participation in the union) is suboptimal and the small country prefers to quit.

Eurozone

The third realistic currency option is for Scotland to use the euro as legal tender. The trade benefits in an informal euro currency union would be dominated by an informal sterling currency union and so we rule this option out. Scotland is expected to be an EU member and therefore is very likely to be required to commit to joining the euro at some unspecified future date. (19) The process involves meeting the Maastricht convergence criteria on monetary and fiscal conditions. Of particular note is the requirement to have a stable currency in an ERM II framework for at least two years before joining the union. This implies Scotland cannot jump from sterling to the euro but would go through an interim period with its own currency. No country has joined the zone without first having a period of time with its own currency. It is unlikely that Scotland would be allowed to be an EU member and use the euro on an informal basis. (20) Hence, we will focus our discussion on the two immediately viable alternatives: a currency union with the continuing UK and an independent Scottish currency.

Debt and the stability of the currency union

We now focus on the implications of government debt burdens for the credibility of a currency union. This builds on the 'off-equilibrium' adjustment paths mentioned in the introduction. Debt matters for the stability of a currency arrangement because it affects the government's room for manoeuvre when an adverse shock eventually hits the economy. When a negative shock, say to tax revenues, hits an economy a credible adjustment plan is required to return to the long-run equilibrium debt path. When a country has its own currency, this adjustment can be any combination of fiscal policy, monetary policy and allowing for the currency to adjust. When a country uses the currency of another country, such as the junior partner in a monetary union, the government only has fiscal policy to restore the economy to full employment equilibrium. Any doubts of investors about the political commitment to make this fiscal adjustment raises the prospect of leaving the currency union.

The argument is clearest by contrasting a low debt with a high debt economy within a currency union. In the low government debt economy, when a bad shock occurs it can borrow at low cost from international markets and repay investors when the economy recovers. By contrast, in the high government debt economy borrowing will be expensive, which will add to the debt burden and raise doubts about debt sustainability. A higher interest rate must be paid on new borrowings and as existing debt is rolled over. At some combination of the government debt level and investors' risk aversion the option of leaving the currency union becomes more palatable than the social and political consequences of making the required fiscal adjustment. Once investors perceive the political calculus has changed this can bring about the very outcome they fear. That is, once borrowing costs rise sufficiently, the incentives for the high debt government to leave the currency union become obvious to investors, and capital flight and/or a speculative attack ensue.

Velasco (1996) provides a useful framework for understanding the impact of government debt on the stability of a currency union. (21) Governments look to minimise the cost of adjusting or transitioning back to full employment. The cost of using either fiscal or monetary policy in isolation increases with the size of the adjustment. This implies that, in general, being limited to use only fiscal policy, as in a one-sided currency union or as the junior partner of a monetary union, will always be more costly than using a combination of fiscal and monetary means, as is possible with an own currency. The added cost of being restricted to only fiscal adjustment is the cost of remaining in the currency union. This cost is balanced by the benefits of remaining in a currency union and the costs of leaving.

In our previous work we show that within a monetary union sovereign borrowing costs are increasing in the levels of government debt and deficits. (22) When a heavily indebted country which already runs a substantial deficit seeks to increase its borrowing further, the interest rate at which it can borrow might rise substantially. This can lead to a vicious circle of higher borrowing costs which further increase deficits and debt, once again increasing borrowing costs, as some southern eurozone members have experienced in recent years. The rising social, economic and political cost of relying only on fiscal adjustment for a heavily indebted country might call the credibility of the monetary union into question: is it really better to pursue the more costly fiscal-only adjustment and remain in the union? Or is it preferable to relinquish the benefits from remaining in the union, and regain the flexibility to use both monetary and fiscal policy? One could argue that the euro survived because of the willingness to move towards greater economic and political union, in contrast to the situation in which Scotland is actively pursuing greater autonomy.

Velasco (1996) shows that the larger the shock--and the larger the initial debt level--the more attractive it is to devalue and the less credible is the fixed exchange rate embedded in the currency union. There are effectively three regions for the level of government debt. In the safe region, with the lowest government debt levels, the benefits of remaining in the currency union always outweigh the costs. In the unstable region, with the highest level of government debt, the costs to remaining in the currency union outweigh the benefits for some values of the shock to tax revenues. In the intermediate range the stability of the monetary union depends on beliefs. If agents believe that the government will stick to the currency union for all shocks, then these beliefs are self-fulfilling. If, however, agents believe that there are some shocks for which the government will abandon the currency union, this sows the seeds of its destruction. Dooley (1988) wryly observed that, "monetary arrangements are given birth at conference tables, and laid to rest in foreign exchange markets".

The Scottish government's White Paper (2013) is admirably clear that, as an independent nation, the choice of currency arrangement in the future must always be open to the people of Scotland. This is the case in any democratic nation. However, it also makes clear to the continuing UK that any monetary union would only last as long as it remains in the interests of Scotland. This questions the ability to impose truly binding fiscal constraints on an independent country, which has so far proved elusive in Europe.

Conclusion

We argue that when considering the optimal currency choice for an independent Scotland it is essential to consider how it would seek to adjust to adverse economic circumstances. In economists' terms, it is as important to think through the 'off-equilibrium' adjustment paths of each of the currency options. The amount of public debt, and so the capacity for a fiscal response, is critical to these paths.

The amount of public debt that an independent Scotland would inherit is critical to the optimal currency choice. The lower Scotland's initial debt and debt servicing burden, the smaller the fiscal tightening necessary to return to a sustainable debt burden, and the less painful any further spending cuts or tax rises would be to the electorate. The less painful is fiscal adjustment, the more likely are markets to believe it to be a credible adjustment mechanism. If Scotland were to find itself with high debt and interest rates, and in the throes of an already painful austerity drive, and were to face a further adverse shock, then markets might question the commitment to remaining in the monetary union.

The Scottish government's acknowledgement that the decision to remain in a monetary union inevitably depends on future governments implies that the commitments cannot be binding in all circumstances. An independent Scotland might find that in future the financial stability advantages to having its own currency outweigh any disadvantages due to trade and transactions costs.

REFERENCES

Armstrong, A. and Ebell, M. (2013a), 'Scotland's currency options', Centre for Macroeconomics, Discussion Paper 2013-2.

--(2013b), Scottish independence and the UK debt burden, http://niesr.ac.uk/blog/scottish-independence-and-uks-debt-burden.

--(2014), 'Assets, liabilities and adjustment in an independent Scotland', Oxford Review of Economic Policy (forthcoming).

Capie, F.H. and Wood, G.E. (2012), Money Over Two Centuries: Selected Topics in British Monetary History, Oxford, Oxford University Press.

De Grauwe, P. and Ji, Y. (2013), 'Fiscal implications of the ECB's bond-buying programme', Voxeu.org.

Dell'Ariccia, G. (1999), 'Exchange rate fluctuations and trade flows: evidence from the European Union', IMF Working Paper 98/107.

Dooley, M. (1988), 'Speculative attacks on a monetary union?', International Journal of Finance and Economics, 3, pp. 21-6.

Fiscal Commission Working Group (2013a), First Report--Macroeconomic Framework, The Scottish Government.

--(2013b), First Report- Annex, The Scottish Government. Flandreau, M. (2006), 'The logic of compromise: monetary bargaining in Austria-Hungary, 1867-1913', European Review of Economic History, 10(01), April, pp. 3-33.

Gourinchas, P. and Jeanne, O. (2012), 'Global safe assets', BIS Working Paper 399.

HM Treasury (2013), Whole Government Accounts, HMSO.

Laeven, L. and Valencia, F. (2012), 'Systemic banking crisis catabase: an update', IMF WP/12/163.

MacDonald, R. (2013), 'Currency issues and options for an independent Scotland', mimeo, University of Glasgow.

Mundell, R.A. (1961), 'A theory of optimal currency areas', The American Economic Review, September.

Nugee, J. (2011), Of Currencies Crises and Completions, SSgA Capital Insights.

Reinhart, C. and Rogoff, K. (2009), This Time is Different." Eight Centuries of Financial Folly, Princeton, Princeton University Press.

Santos Silva, J. and Tenreyro, S. (2010), 'Currency unions in prospect and retrospect', Annual Review of Economics, 2(1), pp. 51-75.

Scottish Government (2013a), Government Expenditure and Revenue Scotland 2011-12, The Scottish Government.

--(2013b), Scotland's Future, The Scottish Government. Thom, R. and Walsh, B. (2002), 'Effect of a common currency on trade: lessons from the Irish experience', European Economic Review, 46(6), pp. 1111-23.

Velasco, A. (1996), 'Fixed exchange rates: credibility, flexibility and multiplicity', European Economic Review, 40, pp. 1023-35.

Angus Armstrong * and Monique Ebell **

* National Institute of Economic and Social Research, Economic and Social Research Council and Centre for Macroeconomics. E-mail: a.armstrong@niesr.ac.uk. ** National Institute of Economic and Social Research and Centre for Macroeconomics. E-mail: m.ebell@niesr.ac.uk.

NOTES

(1) The terms currency union and monetary union both imply the use of a single currency, but a monetary union has a common central bank. The Fiscal Commission Working Group (2013a,b) refers specifically to a monetary union.

(2) Laeven and Valencia (2012) show that for banking crises the average cost in lost output relative to trend in advanced economies is a staggering 33 per cent.

(3) See Scottish Government (2013b) pp. 30, 341 and 554.

(4) The median line is equidistant from the two closest coast lines. It was used to divide the North Sea into UK and Norwegian territories and to demarcate fishing boundaries between Scotland and the rest of the UK.

(5) MacDonald (2013) emphasises the asymmetric impact of oil price shocks on Scotland and the remaining UK as a factor which works against these two regions forming an optimal currency area.

(6) Scotland's First Minister suggested that a division of UK debt on the basis of population would be fair during a TV interview on 11th January 2012.

(7) See Armstrong and Ebell (2013b) available at http://niesr.ac.uk/blog/scottish-independence-and-uks-debt-burden for a discussion of the consequences on fiscal aggregates of how the debt would be repaid.

(8) Scottish Government (2013b) p. 7. The First Minister stated during the launch of the White Paper that the Bank of England and sterling are as much Scotland's asset as London's asset.

(9) Some scholars such as Reinhart and Rogoff (2009, p. 111) suggest that the conversion of loan stock in 1932 was debt forgiveness and therefore a default. Capie and Wood (2012, p. 170) describe how the stock had a final redemption date of 1947 with an option to repay anytime after I June 1929. This is similar to the option in many government and agency bonds today.

(10) An argument can be made that there should be compensation. But it is not clear in which direction this should flow: from the UK to Scotland in return for leaving the reputational value or Scotland to the UK by possibly eroding the reputational value by leaving the union.

(11) Thom and Walsh (2002) p. 1122.

(12) Fiscal Commission Working Group (2013a), p. 123.

(13) The transition to a new currency also raises significant challenges. See Armstrong and Ebell (2013a) for a discussion.

(14) See De Grauwe and Ji (2013) in the eurozone context.

(15) See Gourinchas and Jeanne (2012).

(16) See MacDonald (2013) for a discussion of the real exchange rate between an independent Scotland and UK.

(17) See Nugee (2011).

(18) One vote would approximate a population based representation on the MPC.

(19) To award a small independent country an opt-out when the rest of the union is moving toward greater integration would seem incongruous, although the timing of joining the euro is likely to be unspecified.

(20) Montenegro or Kosovo are very small and the circumstances were so exceptional that they were permitted.

(21) Velasco (1996) analyses the impact of government debt on the credibility of a fixed exchange rate. We understand a currency union to be a special case of a fixed exchange rate.

(22) Armstrong and Ebell (2013a).

Table 1. Summary of an independent Scotland's feasible currency options

Currency Arrangement Transaction Monetary policy
 costs

Scots pound Fixed/pegged Highest costs Central Bank
 of Scotland

 Floating Central Bank
 of Scotland

Sterling Informal None Bank of England
 currency union

 Monetary union Bank of England

Euro Informal Medium costs European
 currency union Central Bank

 Monetary union European
 Central Bank

Currency Arrangement Financial Fiscal policy
 stability

Scots pound Fixed/pegged Scotland No formal
 limits

 Floating Scotland No formal
 limits

Sterling Informal Scotland No formal
 currency union limits

 Monetary union Shared with UK Formal limits

Euro Informal Scotland No formal
 currency union limits

 Monetary union Shared with EU Formal limits