It won’t control interest rates and inequality will widen.
The UK local elections in May saw gains for nationalists in Scotland and Northern Ireland, raising the prospect of increased debates over the future make-up of the country. In Scotland, First Minister Nicola Sturgeon, is hoping to hold a second independence referendum in 2023.
The economic context may have deteriorated since 2014 due to Brexit and COVID, but two key issues remain pertinent: Scotland’s choice of currency and whether its public finances would be sustainable. On both subjects, there are some useful lessons that can be drawn from the last secession from the UK, namely that of Ireland in 1922.
Sturgeon has indicated that an independent Scotland would be open to “sharing” the UK pound for a while to help bring stability. Ireland took the same approach until 1928, when it launched its own currency, the punt, pegged one-for-one to the pound sterling, which made sense because Ireland was heavily integrated into the UK economy.
The peg was managed by a currency board and was comparatively stable for over 50 years. The price for Ireland was the loss of monetary policy, choosing to follow UK interest rates, set by the Bank of England, instead. This is in line with the so-called “policy trilemma” in economics that says that a country cannot maintain a fixed exchange rate, control over interest rates and free capital flows at the same time, but must choose two out of the three alternatives.
Had interest rates not been harmonised, foreign investors might have pulled their money out of Ireland for fear that the currency peg wouldn’t hold and they would lose out as a result. Such a withdrawal would only increase the chances of a currency collapse, potentially making necessary imports unaffordable (this is known as a balance of payments crisis). Indeed, this happened in 1955 when Ireland did not raise interest rates in line with the Bank of England, resulting in a sharp recession and increases in emigration.
Over the years, UK monetary policy was also a constraint on the Irish government’s budget. Although in theory it was free to decide how to tax and spend, the need to maintain the sterling peg prevented various Irish governments from deviating too far from the UK’s approach to borrowing.
