Two key problems Scotland would face using euros after independence

With the end of Czechoslovakia came the end of the currency union and Slovakia introduced its own currency, the koruna.

It was issued by the National Bank of Slovakia, its new central bank located in Bratislava, the capital city of Slovakia.

About a decade later Slovakia joined the European Union. A year after that, in 2005, the Slovak currency joined the European Exchange Rate Mechanism ERM-II in order to prove that the country could live with a stable exchange rate towards the Eurozone countries.

READ MORE: Economist sounds Eurozone 'austerity' warning for Scotland

In 2009, Slovakia then joined the Eurozone and has been issuing euros ever since. It took 16 years from independence to joining the euro.

In case of independence, Scotland will very likely move down the road that Slovakia took. With independence comes a national currency.

It is almost like a law of nature. A central bank will have to be created, issuing Scottish pounds. It will act as the bank of the banks, but also as the bank of the Scottish Government.

This essential task of a central bank is often omitted from debates about the monetary system, although it is a crucial aspect.

Whenever a government spends money, its central bank increases the account of a bank, which then increases the account of the customer who is the receiver of the government's spending.

Money in the 21st century is inherently digital. Cash is just a physical representation of numbers in accounts at banks and central bank. We can make payments with bank card, credit cards and phones without ever resorting to cash.

So, the Scottish Government needs to have a central bank that is reliable in order to ensure that its payments are executed.

What currency the Scottish central bank will issue is up to the government to decide. It can issue Scottish pounds. It could issue euros some day, but only after joining the European Monetary Union (EMU).

It cannot issue pound sterling because the monopoly issuer of that currency is the Bank of England. This means that an independent Scotland will face a fork in the road. Which path to chose?

The euro seems to be very tempting. It is a "fantastic object", a promise of growth and stability, as the Stability and Growth Pact, the European fiscal framework, implies.

READ MORE: Scottish Currency Group: We cannot gift Unionists an open goal on currency

There are two problems with that view. First, the fiscal framework is dysfunctional and not fit for purpose. Second, joining the euro requires a Scottish currency and membership in ERM-II for at least two years.

The first problem is created by the deficit limits that limit public deficits to 3 percent of GDP, a rather random small number.

In practice, this means that Eurozone governments are shy to raise government spending. This translates into stubbornly high unemployment rates of upwards of six percent.

When the pandemic hit in 2020, the rules had to be suspended in order to ensure growth and stability – not a good sign. While many policy makers recognized that the rules are not fit for purpose, the EU returned to them anyway because of the insistance of the German finance minister.

Bringing back the rules and cutting government spending has the Eurozone on the brink of recession.

That is all the more astonishing given the success of the response to the pandemic in the Eurozone. Instead of cutting down government spending with disastruous austerity policies – think about Ireland in the early 2010s – the EU responded by removing the deficit limits.

Governments spent money to address real deficits, like a lack of social and health spending. More spending translated into more demand for goods and services and also workers, which increased employment.

READ MORE: How the Bank of England's arrogance is making the case for independence

Since the Eurozone's unemployment rate currently stands at 6.4 percent, which is a record low, there is no reason to cut back government expenditure. Why send workers into unemployment if they have been doing a good job?

The second problem is that in order to join the euro Scotland has to have stable exchange rate for at least two years. This means that a Scottish currency has to be created before applying for membership in EMU.

Creating a central bank is clearly possible for Scotland, as all other sovereign currencies have their own sovereign money, which they cannot run out of. Scotland's central bank will set interest rates, supply the banking system with liquidity (against what it judges is good collateral), clear payments for banks and make payments on behalf of the government.

There will be a learning curve and it is important for the country to move forward step by step. That means introducing its own currency when independent.

Thus, the question discussed today should be when to switch from British pounds to Scottish pounds and how to design a national central bank.

Joining the EU and joining the euro – if that is a good idea will depend on the evolution of the fiscal framework – will take years if not decades.

The only Western European states that do not have their own currency are Andorra, Monaco, San Marino, and Vatican City. A free and democratic Scotland should not take those as a role model.

Dirk Ehnts shares his thoughts, alongside other Real World Economists, at the Scotonomics Festival of Economics in Dundee
on March 22 to 24. Programme details and tickets to attend in person or online are available from the Scotonomics website.