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Could an independent Scotland have used the pound all along?

An unofficial currency union is 'feasible', says Lord King. But what is one?

By STV News

Published 11 Mar 2016.

An independent Scotland using the pound unofficially is 'feasible', says a former Bank of England governor.

In an interview with Scotland Tonight on Thursday, Lord King, who led the Bank of England for a decade, stated his support for an independent Scotland using the pound without an official currency union.

He said: "I was disappointed in both sides in the referendum. I thought that there was an answer that would solve the independence question - the currency issue. And that is that nothing happens. Scotland just carries on using sterling.

"I think that would have been totally feasible there was no need for an independent currency, that wouldn't have posed any threat or difficulty for an independent Scotland. And I see absolutely no reason why it would have caused a problem for the Bank of England to allow banks to keep on functioning in Scotland."

His comments were welcomed by former First Minister Alex Salmond who described an unofficial currency union - sterlingisation - as "Plan B, if you like". When questioned if he would support sterlingisation at a second independence referendum Salmond said we should "see what emerges at that time" but "it's a very reasonable option to have".

In response to Lord King and Salmond's comments a Scottish Government spokesman said: "The expert Fiscal Commission Working Group considered the currency options open to an independent Scotland in detail, and recommended the adoption of a formal sterling area.

"A shared currency would have been in the overwhelming economic interests of both Scotland and the rest of the UK."

So if Scots had voted for independence, could we have just used the pound regardless of what the UK Government said?

Would it have been beneficial to the economy?

What exactly is an unofficial currency union?

Let's try to answer some of these questions.

An unofficial currency union can take two main forms:

1. Scotland continues using sterling without any arrangement in place.

2. Scotland creates a separate currency but uses a fixed exchange rate mechanism so that 1 Scots pound = 1 pound sterling.

There have been several unofficial currency unions around the world.

Our closest neighbour Ireland used sterling unofficially in the first years of independence from the United Kingdom in 1922. Later in 1928 it moved to the Irish pound which was unofficially fixed to the value of sterling for the next 51 years. From 1979 the Irish pound was officially pegged to the Deutsche mark through the European Exchange Rate Mechanism which laid the groundwork for the euro.

Other past and present examples include: Argentina, Andorra, Denmark, Hong Kong, Kosovo and Montenegro.

Each example has worked with varying success and some, notably Argentina's, had significant negative effects on the national economy.

The fiscal commission went on to conclude that "two clear options for Scotland are therefore to seek to join a formal monetary union with sterling or the euro."

No, to put it bluntly.

The currency issue is one of the most hotly debated subjects surrounding independence.

We asked two leading figures to give their say.

Research professor of macroeconomics and international finance, Adam Smith Business School, University of Glasgow

"Sterlingisation in any of its forms - formal or informal - is a very bad idea for an independent Scotland since it means that the exchange rate (the rate at which the currency of an independent country trades with its main trading partner, the rest of UK) is rigidly fixed at a one-to-one parity. As we have been recently reminded, the oil sector plays a dominant role in the Scottish economy, both in terms of employment and economic activity, but also in terms of the fiscal deficit which is currently around 10% of GDP and would not be sustainable in an independent Scotland, requiring cuts to public spending and probably tax rises.

"Scotland's fiscal deficit is, however, sustainable as part of the fiscal sharing agreement it has from being part of the UK. An independent Scotland, by definition, would not have such a fiscal sharing agreement but would desperately need to become more competitive in its non-oil private sector to help create jobs for those shed in the oil and public sectors (due to the expenditure cuts).

"With a fixed exchange rate this can only be achieved by wage and price cuts - the so-called internal adjustment mechanism that Greece has had to undergo. But with an independent currency that is not tied to sterling and is free to adjust (a flexible exchange rate) this would bring about adjustment much more quickly without the need for a protracted period of recession such as Greece has faced."

Executive director, Adam Smith Institute

"Mervyn King is quite right that some form of sterlingisation would have been an independent Scotland's best bet, had it voted for independence. Though what he describes is a formal currency union, where the Bank of England operates with Scottish macroeconomic stability as one of its goals, I proposed that Scotland go it alone with an informal currency union. This would emulate the old Scottish 'free banking' era in the 18th and 19th centuries where banks issued their own notes, backed then by gold and now, I suggested, by Pounds Sterling. This would mean that they could expand and contract their balance sheets depending on people's demand to hold money, a natural counterbalance to the boom and bust cycle.

"The old free banking era was a remarkably prosperous one, and Adam Smith himself attributed this prosperity to Scotland's unique banking system. For this to work it would be important for the Scottish government to rule out bank bailouts or government deposit insurance of any kind, so that banks would have to act prudently without the promise of being rescued if they collapsed.

"I think balance of trade issues are overstated by some economists - they certainly can be a problem, but with Scottish banks free to expand and contract their balance sheets, the problem that Greece has faced - chronic nominal GDP shortfalls - would probably not be a danger."

That's fine. The current Scottish Government does not have an official timetable set for a second referendum so we could be debating this for months, years or decades.

So there is lots of time for you to get to grips with fixed exchange rates, liquidity flows and the importation of interest rates.

News analysis by Aidan Kerr, STV's digital politics reporter. You can contact him at aidan.kerr@stv.tv