ANY currency regime poses a trade-off between financial stability and flexibility to boost growth, job creation and investment. More of one means less of the other. This may be true in the short run, but definitely not in the long run as the Irish examples (or the section on floating) below show. The way out is to use currency/monetary policy to provide stability, and internal policies to provide flexibility.

READ MORE: Economist Andrew Hughes Hallett backs FM's pound plan

Otherwise the conflict will be between do you want to preserve the value of your pension, or flexibility in the (vain) hope of boosting growth to create new pensions?

Explaining the currency options

1. (Multilateral) Currency Union

ALL participants share a single currency, hence a single monetary policy (interest rate) and a single exchange rate. The important point is that all participants, however small, contribute to making the decisions on what that single monetary policy/exchange rate should be. Small countries will have little separate effect, but the principle is there. Most likely, but not absolutely certain, this will involve sharing a common financial and prudential regulatory framework. It was this last part that the Bank of England refused to allow in 2014; but the European regulation framework could have been used instead (with the UK then in the EU).

The only existing currency union of that kind is the Euro System, unless you want to include the US Federal System with its regional feds having partial policy voting power. The UK currency union is not of this kind, being a unilateral union with no regional inputs. It seems unlikely, Scotland having been in that position for 300 years, that we could get a step up at this point. On the other hand, Scotland loses nothing by not getting an upgrade.

2. (Unilateral) Currency Union

THIS is where you simply chose to use the currency of another economy whose monetary management appears to be more disciplined than yours or in line with your goals. No one can stop you doing that, but you do have to take the interest rates and exchange rate of the other economy. However, in compensation, you get greater financial stability, certainty or financial protection from bad shocks than you could manage on your own. If you wish to pursue your own goals, different from the other economy, you have to use internal policies (fiscal policy, diversification, competitiveness, productivity policies) to make up the difference. You are always free to do that, but as a small economy the scope for doing so in practice may be limited.

There are a number of examples where this regime has been surprisingly successful: Ireland after independence; also Ecuador, Panama and Montenegro, whose performance has been very strong when compared to what went before.

3. A Currency Board

IN this regime, you are able to issue your own currency but only 1-1 as each unit of the currency (or basket of currencies) to which you are pegged comes in through trade or investment. This is relatively easy to organise, but does depend on maintaining strong governance arrangements and a sensible choice of currency/ies to peg to (reflecting the pattern of trade and investment partners). It is fair to say that Argentina fell down by a poor choice of, and weak enforcement of, the governance arrangements, and by choosing the wrong peg currencies when they tried this option in the 1990s. And we face the same restricted room for manoeuvre for small countries if they wish to maintain both financial stability and flexibility in pursuit of their goals.

If a proposal for Scotland were implemented along these lines, the gains over other currency regimes could easily be more apparent than real.

On the other hand, there are instances where this regime has been outstandingly successful in securing financial stability and the growth, low inflation, job creation goals Scotland needs: eg the Baltics in the 1990s, China and most of all Hong Kong since 1977. Who would not want that? These examples make a strong case for a customs board, if properly designed and managed, as part of the Sustainable Growth Commission’s proposal.

4. Floating (a pure or managed float)

HERE your own currency’s value is left to fluctuate with market forces, perhaps with interventions to buy (sell) the currency from reserves to smooth out the larger fluctuations on the down (up) side. Typically this works as long as there are reserves left with which to intervene. But then the ability to maintain a coherent currency regime is gone (and with it any financial stability). This is because the financial markets are much larger than official reserves, so speculative attacks always win out. Look at the destruction of the EMU system in 1992-93.

On the other hand, the loss of financial stability may be partially compensated by greater flexibility to pursue domestic goals by domestic monetary policy (devaluing to generate additional demand, growth and jobs). This is possible in the short run. But it would generate extra inflation because imports cost more, and hence losses in competitiveness that destroy that extra growth and those jobs; in which case nothing has been gained but quite a lot lost (not least because Scotland would have signaled that she had chosen a regime to try the same trick again when circumstances get difficult).

There is no advantage to accelerating that effect by signaling it in advance by cancelling the six tests. It takes very little in extra inflation to create a loss in competitiveness. Much better to try to get the same flexibility by using domestic policies: fiscal policy, structural reform, productivity growth.

There are lots of examples where this floating strategy hasn’t worked well – Mitterrand in France in the 1980s; UK at various times; Italy. But the clearest example is Ireland in the 1979-1982 period – but none where it has worked in the absence of support from internal domestic policies.

What impact could the SNP leadership position have on EU membership?

THE Sustainable Growth Commission does not take a position on EU (or Euro) membership. But its recommendations are carefully constructed to at least keep open the prospect of EU membership. And a currency framework designed to ensure financial stability will make Scotland’s membership more attractive from an EU perspective.

How would the Sustainable Growth Commission proposal work – and would we have to join the euro?

THE unilateral currency union part of the proposal is fairly straightforward. It would work as now, once the question of financial regulation is settled. Various options on how to settle that question are discussed in the commission’s report, including those not dependent on the UK.

The second (currency board) part is more subtle. Here is one possibility, though what would finally be adopted is a question for the Scottish people and Scottish Parliament to decide. The main concern with a currency board is whether it has sufficient reserves and discipline to weather a severe recession or speculative attack. One of the purposes of the six tests is to demonstrate that it has. And one of the purposes of the first (currency union) part is to allow the new Central Bank time to establish a reputation for focused and consistent policy making; also to amass sufficient reserves or support arrangements (Scotland’s share of foreign exchange reserves, public sector asset sales, quantitative easing assets, oil revenues in the fund for future generations etc).

That done, the six tests, to be undertaken by the new independent Scottish Central Bank, will signal that the Scottish economy is stable, and is likely to remain so, and has sufficient reserve arrangements to support it. It will also signal to the EU that Scotland is in a position to join the EU or Euro if it wanted to (no promises, that is up to the Scottish people, but the necessary test is passed).

This then implies a judgment on the suitability of going to another currency or a currency board; and after that an agreement on going into (or possibly a derogation, Danish style) the Euro as part of the, by then, post-independence negotiations on readmission into the EU. Obviously it is the timing that is important here. In the two stage validation, it is the last part that gets you the ECB’s under-writing of the exchange rate that Denmark enjoys. It depends on the possibility (not more) that you will enter the Euro process (not the Euro per se) when in a condition to do so. This is a gentleman’s agreement; all new members (absent a derogation) have to agree a willingness to join the Euro process when they are in a position to do so. But it is not enforceable as Sweden’s case shows only too clearly.

Are there lessons to learn from Ireland’s currency transition?

THE transition to a new currency regime in Ireland took a broadly similar path to that now proposed for Scotland, albeit with a different timing to reflect the fact that the Irish economy was far more integrated through trade and investment with the UK than Scotland now is (not to mention differences in income levels, civil war in Ireland, the Second World War etc). So the transition took longer.

From independence in 1922 to 1943, Ireland operated with a more restricted form of unilateral currency union than that proposed for Scotland (for example, Ireland did not control her currency/banking reserves to defend against adverse financial shocks). After 1943 Ireland switched to a fairly strictly enforced currency board, pegged to the UK pound. This worked pretty well and laid the foundation for steadily increasing prosperity and an expansion of trade and investment (principally to the US).

However with the demise of the sterling payments area and Ireland’s preparations to join the EU in 1973, this era came to an end. Ireland then joined the European “snake” currency regime which was dominated by rather frequent devaluations and revaluations, and the steady growth of previous years was lost until she joined the more disciplined EMS regime in 1979.

However the snake period and several adjustments to find her place in the early EMS years meant that Ireland was a de facto float until the EMS rules were tightened up in 1986 (the so called “hard” EMS regime). In this period the Haughey government tried at least two unilateral devaluations (1978-82) to restore the growth and jobs enjoyed in earlier years, but to no effect. Inflation and higher interest rates killed off higher growth in the short term, and the economy, now significantly less competitive, reverted to sluggish growth, high unemployment, high interest rates and considerable financial uncertainty that proved difficult to escape.

Progress came when the Fitzgerald government was able to agree a further devaluation, but with the difference that all parties to the policy process (including trade unions) agreed not to pass on or compensate for any inflationary effects in prices and wages – and on the understanding that this all had to be done strictly within the rules of the hard EMS. This worked, and led to the 20 years of 5%-7% growth, job creation and investment that followed.

If there is a lesson for Scotland, it is that there may be a trade-off between stability and flexibility, but it is only in the very short run. In the medium to longer term, increases in competitiveness and productivity derived from domestic policy in a stable regime are far more powerful. This is perhaps best summed up by the Central Bank of Ireland’s former governor Patrick Honohan; the success of the movement from currency board to central bank was “in contrast to many other post-colonial cases, (the currency board’s) demise was not followed by a rapid depreciation and slide into semi-permanent high inflation and lack of convertibility”.

Andrew Hughes Hallett is an honorary professor at St Andrews University school of economics and member of the Sustainable Growth Commission