An independent Scotland must abandon the pound

Alex Salmond wants out of the UK. He wants a sovereign Scotland, independent of London for the first time since 1707 - and he might have the votes to make it happen. His new Edinburgh parliament would be free to tax, spend and legislate as it pleased. But Salmond and the SNP are happy for London to retain control over one important part of Scottish life - their money.

Under the SNP's plans the new Scotland would retain the British pound. Scotland would continue to import monetary policy from the Bank of England at Threadneedle Street. Why does a strident nationalist like Salmond want London to run Scotland's money? And why does this matter?

Ireland's lesson for Scotland

Ireland left the UK in 1922 after a long and terrible struggle. Irish nationalists glorified Grattan's Paliament', a short and prosperous period of Irish sovereignty at the end of the 18th century, and they imagined that independence would lead to riches.

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It didn't. The country started out respectably wealthy on the eve of World War 1, but its performance for most of the rest of the century was dreadful, and it slid down the European income league.

From about 1920 to 1990 Europe's wealth converged - the countries that were poorest at the outset like Spain and Greece grew fastest, and the richest countries like Britain grew most slowly. But Irish wealth fell, then did not recover.

The new country's first leaders were conservative. Despite their nationalism, they decided that the new Irish pound would stay pegged to the pound sterling at a rate of 1 to 1 - so that in monetary terms, Ireland never left the UK.

Ireland's economy adjusted slowly to life on the outside. Trade with Britain dominated exports for decades, growth was slow, and the people emigrated in their droves. A currency helps a nation to adjust to changes in its circumstances. Ireland did not have a currency, and it did not adjust.

Short cut' to a stable economy

Exchange rates are utterly flexible. The pound price of dollars adjusts every second of the trading day. But the prices in our lives are not like that. They adjust slowly, and variably. If they're the price of labour - wages - they adjust very slowly, and they don't easily adjust downwards.

If everyday prices were as flexible as exchange rates, there'd be no need for currencies. Prices would adjust instantly to match supply and demand and clear markets. Nominal rigidities' - in economics jargon - mean that this doesn't happen. Discovering the right price level is a slow process of trial and error and it can take years.

Rigidities' have important consequences. For example, employees hate wage cuts. So when employers need to cut costs, they tend to fire workers rather than cut wages across the board. This means that when the demand for employment falls, it can take a long time for wages to adjust to bring the market back into balance.

A national currency is a short-cut. It's how a country works around the problem of inflexible prices to ensure its output is priced right - not so cheap that there's not enough supply to meet demand, not so expensive that there's not enough demand to meet supply.

Say Scotland were to launch its own currency after independence. If it underwent a shock' - like a plague of midges that kills demand for holidays in Scotland - the Scottish exchange rate would adjust to cushion the blow. It would instantly make Scottish holidays cheaper relative to French holidays. Scots wouldn't be able to afford to leave and foreigners would be tempted by the bargain prices, so people would holiday with the midges.

Without the exchange rate short-cut, the shock would look very different. The midge swarm would scare off tourists, foreign and domestic. Prices would only fall after a long, painful period of grinding deflation and unemployment.

Or another shock' - say Israel bombed Iran, sending the price of Scottish oil soaring. Now, money would pour into Scotland. That would fuel inflation, asset prices and debt. A national currency would mitigate this by rising in value. Without a currency, the country would be at the mercy its own rising prices.

Money is too important to delegate

Of course, Scotland doesn't have its own currency at the moment and it does OK. But there's a different adjustment mechanism right now - transfers with the UK exchequer. A shock in Scotland means money moves across the border from (or to) the south to help with the adjustment. That might be money going north to pay for unemployment benefits during a midge plague, or money going south to prevent inflation during an oil boom. That's how the different regional economies of the United States fit together. Booming Texas sends taxes to Washington, depressed Nevada receives spending from Washington.

So there are three different ways a country can adjust to shocks. Its currency can adjust; it can send or receive capital across the border from another state; or it can work the shock through the system by slowly discovering billions of new prices at ground level.

Leaving the union would leave Scotland with no easy way to deal with shocks. An independent Scotland wouldn't get transfers from London and its currency wouldn't adjust either. The burden would have to fall on prices. That could mean overheating and inflation during a boom and unemployment and deflation during a bust.

Ireland understands these adjustments better than most. Eighty years after Ireland delegated responsibility for its money to London, it delegated it to Frankfurt. When Ireland first joined the euro the celtic tiger' was nearing its peak. With no control over monetary policy or currency; and no fiscal transfers within the eurozone, the economy roared ahead... for a while. Capital poured in, the property market went into the stratosphere, wages and prices followed.

Since 2007 Ireland has faced the other type of shock. Nobody wants all the things it used to produce. If it had its own currency, its value would adjust to reflect this. If it were part of a bigger state, it would receive transfers from the whole. But it's neither, so the adjustment has to come from prices. As Ireland and peripheral Europe show us, finding prices is a slow and ugly process. On the way up it meant rising inflation and debt, on the way down it means mass emigration, mass unemployment and social unrest.

Alex Salmond wants an independent and prosperous Scotland. If he succeeds and Scotland's economy roars ahead, leaving the rest of the UK behind, their shared currency means a crash won't be long following. If he gets independence, but can't deliver the prosperity, it'll be tougher than ever for Scotland to catch up. The fact is, political independence would be cold comfort without prosperity, but monetary dependence could preclude that prosperity. If Scotland is to go it alone, there can be no half-measures: it must abandon the pound.