Scotland should create its own currency

The battle promises to be a good one at least for spectators. And it may well determine whether Britain remains a single country, or whether Scotland becomes independent.

Next month, the British government will make it clear what currency an independent Scotland should have if that is what the country votes for in the referendum scheduled for next year. It will argue that Scotland could keep the pound, but only if it accepts strict control of its budget. But the Scottish Nationalists are arguing they should keep the pound free of any conditions and have a share in the Bank of England. Both sides have got this wrong.

The issue of which currency an independent Scotland would have is likely to be crucial to next year's vote. Sentimentally, most Scots would probably favour full independence from the UK at least that is what they would appear to want if they vote for the SNP. But if they think it will make them poorer, that may well persuade them to stay inside the union indeed, even the threat of economic instability will be a powerful reason for maintaining the status quo.

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Until recently, the SNP could just argue Scotland would join the euro. While that was still a successful, stable currency, it was a viable position. Now most Scots would probably rather merge their currency with Iceland than with Ireland or Greece. Instead, the SNP now argues Scotland should keep sterling and, indeed, that it should have a say in how it is run to make sure that monetary policy benefits the Scots as well as the English.

That is all very well but what's in it for the English, Welsh and Northern Irish? The paper to be published next month will argue that Scotland can keep the pound but only if the Bank of England is allowed the same powers to control budget deficits in Scotland that the European Union now has over deficits in Spain, Italy or France.

That may work for the Scots but not for the English. In truth, if Scotland wants to break away from the rest of the country, it should be told that it will have to create its own currency. Here's why.

First, the eurozone has shown that countries that share a currency need tough rules on government deficits. It is perfectly right that Scotland, if it shares the pound, should have to submit its budget plans to English control.

If the Scottish run huge budget deficits, the Bank of England will ultimately be responsible for them, just as the European Central Bank is ultimately responsible for Italian or Spanish debts. If you are expected to pay for something, you have to be allowed to control it.

The trouble is, Maastricht-style rules on deficits don't work. They were built into the euro for exactly the same reasons. And what happened? Everyone ignored them. There is no realistic enforcement mechanism. The Bank is not going to send tanks into Edinburgh any more than the EU was going to send tanks into Athens when the Greeks were blatantly ignoring the deficit rules they were meant to be sticking to. It isn't going to work. The Scots can simply run up bigger and bigger deficits and, if necessary, hide all the figures off the balance sheet.

Next, the political cultures of England and Scotland are too far apart. Again, the euro has shown that putting countries that want very different economies into a currency union doesn't work. Scotland would be a big-state, Scandinavian-style country and would inevitably move more and more in that direction after independence.

By contrast, England would be a small-state, free-market country and is likely to move further that way if Scotland breaks away. Bear in mind that England would be more or less permanently ruled from the centre-right, while Scotland would have virtually no right-of-centre party. That is a huge gulf in outlook. Can a few fiscal rules paper over those cracks? The lesson of the euro is that it will all come apart in less than a decade.

Finally, the English would be missing a trick by allowing the Scots to share their currency. It might be cynical, but if Scotland is going to break away, the English should make a bid for the finance industry based in Edinburgh.

Outside of the City of London, it is one of the biggest and most successful financial centres in Europe. But by allowing Scotland to use the pound, the Bank of England would be giving an implicit guarantee to all those Edinburgh-based banks and fund managers.

Surely it would be better to withdraw it and encourage them to move to York, Manchester, or, indeed, London? Quite a few may decide it was easier, and a lot safer, to shift their headquarters a few miles south than risk the flight of capital that might result from losing the Bank's protection. England could use the jobs and wealth that would come with them.

It is up to the Scots to decide on independence. But if they go for it, they will need to create their own currency or else join the euro. There is no need for the English to help them out. It won't work and even if it did, the English would be losing the chance to take jobs and wealth from what will by then be a competing nation across the border.