The weird notion of a Sterling zone
Prior to the creation of the Euro, many macroeconomists from various different backgrounds (but especially modern monetary theory) warned that the Euro had an inherent weakness. That weakness was that the nations comprising the currency zone were fiscally sovereign, but not monetarily sovereign. In order for a fiscal sovereign to have strong credibility — to avoid bond vigilantism, and all that — it must be to a decent degree capable of printing up media of exchange to be able to avoid running out of money. The Euro created a system where governments were capable of running out of money — mimicking the gold standard — and inevitably this has led to fiscal crises and bond vigilantism.
In other words, for a currency union to succeed it also must be — at least to some extent — a fiscal union. If not, there will at some stage be at best dysfunction, and at worst breakup. The Eurozone has managed to smooth some of the panic in markets through Mario Draghi’s expansionary monetary policy, and by enacting the European Fiscal Compact which is a step closer to a fiscal union although one that in the long run may do more harm than good as it demands balanced budgets, which leaves governments powerless to spend borrowed money to fight unemployment and invest in infrastructure in a slump.
This gradual trend away from a monetary union and toward a fiscal union was even anticipated by E.U. officials. In fact, Romano Prodi — at the time the president of the European Commission — as early as 2001 warned that "I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”
So it is especially weird that Alex Salmond wants Scotland wants to leave the United Kingdom, but remain part of a Sterling zone. Scotland would be fiscally sovereign, and monetarily not so. Salmond seems to want to take the fragility that has wrecked Greece and Spain’s economies, leading to 25% unemployment and a huge, cataclysmic depression and introduce it to Britain. This is especially jarring, given that Scotland is already quite independent, with vast room to manoeuvre in terms of domestic policy, yet fiscally bound to Westminster, insulating Scotland from the prospect of fiscal crises and bond vigilantism. That is probably the best possible end state in the Eurozone, and yet Salmond wants to go backward.
Mark Carney very correctly slapped down Salmond’s nonsensical proposal this week, telling Salmond that Scotland would need to give up significant areas of its sovereignty and reach a watertight deal with Britain on banking, taxation and spending if a new sterling zone were to avoid the risks and instability which had plagued the euro. In other words, in Salmond’s vision of a Sterling zone, Scotland would not really be sovereign.
The alternatives for Salmond would either be to join the Euro — good luck pursuing a progressive anti-austerity agenda with Angela Merkel holding the purse strings, Alex — or to introduce its own central bank and mint its own currency, a costly, complex and risky endeavour to accomplish from scratch
Now, perhaps I am also a little uneasy toward the idea of Scotland breaking away and striking out on its own because Scottish independence would create a seemingly unbreakable Conservative majority in Westminister. Scottish progressivism is a counterbalance to English conservatism in our union, producing a mixed economy featuring both a relatively free market as well as social safety nets. Losing the counterbalancing forces could be bad for both countries, but probably worse for Scotland as Scotland — whose banks make up a very large share of its GDP — faces a real risk of becoming the next Spain, Greece or Ireland either in the Eurozone or the Sterling zone.
Fortunately, I think most of this discussion is hot air. As Nate Silver notes, Scottish independence is a very unlikely prospect compared to Scotland reluctantly remaining in the union, and bookmakers agree. It is, at most, a tail risk. But what a nasty tail risk.