Currency choice: what lessons from Ireland for an independent Scotland?

Monetary and fiscal stability were key issues during Scotland’s 2014 independence referendum. Independent Ireland’s experience of navigating alternative currency options and their implications for fiscal policy may offer lessons for the present.

Supporters of Scottish independence often cite Ireland as a neighbouring example of the benefits of independence. Conversely, Ireland’s financial meltdown between 2008 and 2012 is highlighted as a warning against independence, particularly as the Irish government’s policy choices were constrained inside the euro area.

Comparisons between the independence movement in Ireland a century ago and recent campaigns for Scottish independence can be called into question because of differences in the political context, notably Ireland’s militarised home rule (Jackson, 2014). Yet such filtering overlooks potentially valuable lessons for navigating independence. Specifically, currency and fiscal stability were key issues in Scotland’s 2014 independence referendum and these debates remain unresolved. What lessons can Ireland offer?

Context

Ireland achieved independence in 1922 ‘under the most unfavourable circumstances that could have been imagined’ (Meenan, 1970). Ireland’s population was under three million, and while the country was relatively advanced in terms of services, it was dependent on an underdeveloped agricultural sector. Today, it represents one of the fastest growing economies in Europe (Ó Gráda and O’Rourke, 2021).

But Ireland did not prosper in the decades after independence (see Figure 1). It underperformed compared with richer countries towards which it may have been expected to converge during the period. It also fell well short of countries with similar initial income levels, such as Norway, Finland and Italy. As one study notes, ‘that the Irish economy, so closely linked to the UK, grew sluggishly in the 1920s should come as no surprise’ (Ó Gráda and O’Rourke, 1996).

In the 1920s, the prime preoccupation was to establish the legitimacy of the new state, while the new government elected in 1932 was focused on issues of sovereignty. During the Second World War , the security of the neutral state and economic survival necessarily took precedence, leaving insufficient space for attention being focused on economic development (Kennedy et al, 1988). Contemporaries compare it unfavourably with other UK regions (for example, FitzGerald, 1956; Meenan, 1970)

Some argue that trade openness can offset the impediments of country size (Alesina et al, 2000). Yet Ireland seceded during a period of increasing protectionism. Only in 1973 did it benefit from the increasing openness that the European Economic Community (EEC) offered – which is seen as a cornerstone of its later success (O’Rourke, 2017). But such openness and integration would present new policy challenges for Ireland.

Figure 1: Comparative growth performance

(A) 1926-1960

(B) 1926-2018

Sources: Maddison Project Database, version 2020; UK regions from Rosés-Wolff database, 2020
Note: Ireland based on GNP because GDP is much greater than GNP (and the distortion much greater than for most other countries included); Irish GNP from Gerlach and Stuart, 2015

Currency regimes

Over the century since independence, Ireland has had five currency regimes and only exercised ‘monetary independence’ for less than a decade. In the immediate post-independence era, sterling was the de facto currency, followed in 1927 by a one-for-one peg with sterling against the Irish punt. This occurred exactly one century after sterling and the Irish pound were merged into a single pound under the Union.

The post-independence sterling peg lasted until 1979, when Ireland joined the European Monetary System (EMS), which operated a multi-country adjustable peg system – the exchange rate mechanism (ERM). Ireland operated a floating currency in the 1990s until it joined the euro area in 1999 (Honohan, 2019). Therefore, for almost two centuries, Ireland had no experience of independent monetary policy.

The post-independence choice of currency regime evolved with prevailing economic conditions. Following independence, sterling was the obvious peg of choice as Ireland’s dominant trading partner was the UK, Irish banks had sizeable sterling assets in London, and sterling was seen as a stable currency (in the context of hyperinflation elsewhere). A number of former UK colonies, such as Australia and New Zealand, had adopted a sterling peg but decoupled soon after independence. Ireland was the last ex-colony to maintain its peg, because of its traditional integration with the UK economy (Honohan and Murphy, 2010).

The appropriateness of the sterling peg weakened over time as Ireland’s economic dependence on the UK decreased and the perception of sterling’s stability receded. Ireland’s accession to the EEC in 1973 – alongside Denmark and the UK – offered the potential for the development of new trading relationships (see Barry, 2014; de Bromhead et al, 2021).

This, coupled with various sterling crises, encouraged policy-makers to consider an alternative currency regime, which would break historical ties with sterling (Honohan, 2019). The adoption of each monetary regime did not represent ‘voluntarist policy action’, but rather reflected a ‘passive approach to shifting external norms initiated by Ireland’s economic and political partners in Europe’ (Honohan, 2019).

Currency board or central bank (1926-1979)?

Ireland had experience of fiscal administration through the offices of Dublin Castle during the Union (Hynes, 2014). Joseph Brennan, one of the key architects of the Department of Finance, had worked as head of the Finance Division in the Chief Secretary’s Office in Dublin Castle. The political temptations to engage in fiscal stimulus were strong, set against the promises of independence and the Irish debt relief of 80% of GDP (FitzGerald and Kenny, 2020).

The sterling peg shielded the administration from such pressures, as post-independence Ireland was required to experience similar trials to its neighbours, in restoring the pound to its pre-war gold parity. Deflationary pressures acted on the economy as the Irish Free State (IFS) adhered to balanced budgets and ‘sound finance’ in the 1920s (Daniel, 1976). Expansionary fiscal policy was therefore proscribed as a region of the sterling zone if parity was to be maintained.

Ireland had been a net contributor in the UK exchequer in the 19^th century, but this pattern was reversed by the early 20^th century when the country received fiscal transfers in the form of pensions and land purchase (Jalland, 1983). There was a view in Ireland that greater fiscal autonomy would allow the reduction of indirect taxes that affected the poorest.

Instead, post-independence Irish income tax rates were reduced in order to contain capital flight and the small income tax base that threatened to migrate (Meenan, 1970). It was politically impossible to provide lower pension and other social welfare benefits than those that were inherited from the UK. A similar problem would face contemporary Ireland should Northern Ireland secede into a united Ireland (FitzGerald and Morgenroth, 2019).

In 1920s Ireland, pensions remained ‘in a class of their own’ dwarfing other categories of social welfare payments, and represented a ‘boon’ to the aged poor (Ó Gráda 2000, 2002). While UK pension payments consumed 5% of government expenditure and over 1% of GDP by 1930, the Irish equivalents still stood at 13% and 2% respectively, even after substantial cuts (Ó Gráda, 2000). Although these cuts occurred during a period of deflation, they had political ramifications for the incumbent government (Hynes, 2014).

While the IFS Department of Finance was structured along the lines of HM Treasury (Fanning, 1978), there was no obvious template for how to operationalise monetary independence (Drea, 2015). The League of Nations’ financial conferences in Brussels (1920) and Genoa (1922) had recommended that newly independent countries should establish central banks of issue (LON, 1920, p. 235; FR 1922, p. 678).

Many newly independent countries did so, though IFS officials were hesitant to institute any sweeping reforms to the existing monetary system. Ireland had been part of a monetary union with Great Britain since 1826 with the Bank of England acting as the central bank for the entire UK.

The Bank of Ireland, founded in 1783, was also one of Europe’s oldest ‘national’ banks (Capie et al, 1994). Historically, it performed several functions of a national bank. For example, it served as a banker to the new state and it had previously acted as lender of last resort during a number of banking crises (Kenny and Lennard, 2018). But commercial rivals and critics resented its political and financial privileges. As it had traditionally functioned as a protestant and unionist institution, a politically palatable alternative was sought instead (Barry, 2021).

Subsequently, the IFS government created a commission of inquiry into banking and currency in March 1926. Chaired by Henry Parker-Willis, of Columbia University, it delivered its first report within six weeks, owing to the urgency and importance of its brief (Moynihan, 1975). The committee recommended a ‘definite acceptance and continuance of British sterling as a standard of value in Saorstát Eireann’ (Parker-Willis et al, 1926).

The rationale behind this decision was primarily due to historic trading links with the UK and the perception that a weaker currency was disadvantageous. The stance suited the conservative Irish finance minister, Ernest Blythe: ‘I recognise very fully that any change in the currency position at the present time would have serious reactions’ (27 January 1926). Significantly, the Commission noted that the sterling link could be revisited when the ‘business going to other parts of the world will undoubtedly increase’ (Parker-Willis et al, 1926).

The Irish Currency Commission – effectively a currency board – was duly established, based on the Commission’s recommendations. The institutional structure, modelled on the US Federal Reserve system, aimed to serve and evolve with, rather than alter, the existing monetary system (Pratschke, 1969; Drea, 2015). Adherence to the gold standard remained a core tenet of the system.

Set against the backdrop of the instability of the interwar years among many newly independent countries in Eastern Europe, some argue that Ireland’s comparatively mundane monetary history should be celebrated (Drea and Barry, 2021).

By 1943, Ireland had converted its currency board into a central banking organisation, in line with other post-colonial countries (Capie et al, 1994). Adopting a cautionary approach, it did not expand its activities materially beyond those of the Currency Commission (Moynihan, 1975). Whether the Central Bank of Ireland (CBI) operated as a central bank before the 1970s is debatable (Honohan, 1997). But, in 1955, the CBI experimented with declining to raise its rate of interest in line with the Bank of England, as had been tradition. The result was a devastating balance of payments crisis and, in 1958 (see Honohan and Ó Gráda, 1998), the highest levels of emigration since independence were recorded (Ó Gráda, 2011). When rates were realigned, a ‘draconian’ fiscal response was employed to rectify the trade balance (Ó Gráda, 2011).

The episode highlighted the importance of monitoring external balance within a currency union, as a small independent region. It also provided a painful example of internal devaluation via fiscal austerity as a means of rectifying such imbalances. Fifty years later, the lesson was long forgotten.

The close relationship between the UK and Irish currencies was reflected in inflation rates (see Figure 2). The European reaction to the end of the Bretton Woods monetary system in 1971 was the ‘snake in the tunnel’ system, which aimed to limit fluctuations between different European currencies within pre-arranged bands. Following the UK’s withdrawal of sterling from the ‘snake’ arrangement in 1972, Irish authorities’ concerns that the pound would weaken, and UK inflation would be imported to Ireland grew (Kelly, 2003). By 1978, they were increasingly in favour of joining the EMS, which was initiated in 1979.

This decision was motivated by:

the inappropriateness of an indefinite prolongation of the sterling link;
the benefits of a reduction in inflation from adherence to a hard currency regime;
commitment to a major community initiative;
and community support in the form of transfers (Kelly, 2003).

Under the EMS, the punt was allowed to fluctuate within bands of +/- 2.25% of the ERM, although it was unilaterally devalued on two occasions in 1986 and 1993 (Conroy and Honohan, 1994).

Figure 2: UK and Ireland inflation rates

Source: Bank of England millennium of macroeconomic data and Central Statistics Office of Ireland
Note: Vertical line in 1979 to highlight the break of sterling peg

After the pound (1979 onwards)

When sterling was abandoned in 1979, expectations that the punt would increase in value against sterling prevailed (Dáil Éireann debate, 1978). There was an associated concern regarding the consequent ‘adverse effects on the balance of payments and foreign reserves’ (Quinn, 1978). Conversely, the punt instead lost value against the pound on floating, as the latter gained value due to North Sea oil and deflationary policies pursued in the UK (see Figure 3). It was not until the 1990s that the punt strengthened against sterling.

Figure 3: Irish punt to UK sterling exchange rate, January 1976 to December 1998

Source: Central Bank of Ireland

For fifty years, the sterling link had ‘been accepted by successive governments, by Dáil Éireann and by the public at large as being, on the whole, in the best interests of the community’ (Moynihan, 1975). It has been argued that the contrast between the instability of the ‘floating’ exchange rate (between 1979 and 1998) and the stability of the sterling peg consolidated support for the adoption of the euro in Ireland from 1999 (Honohan, 1997). Ireland retains one of the highest support ratings for the euro in Europe (European Union, EU, 2021).

Did currency regime stability come at the expense of development? The sterling link provided price stability, but it remained controversial, perpetuating Irish trading links with a sluggish post-war UK economy. One variety of this argument posits that by continuing to peg to sterling, Irish enterprises were not exposed to dynamic markets elsewhere in Europe (Honohan, 1997).

Table 1 shows growth of gross national product (GNP) – a measure of the value of goods and services produced by a national economy – and inflation through various currency regimes, suggesting no apparent trade-off between development and monetary stability. Ultimately, ‘the choice of currency regime is less decisive for economic performance than is often supposed’ (Honohan, 2019).

Table 1: Growth and inflation rates under different monetary regimes

Monetary era	GNP per capita growth rate	Inflation rate
Free currency era (1922-1926)	0.31	-4.33
Peg
Full period (1927-1978)	2.17	4.83
Currency Commission (1927-1942)	1.10	2.06
Central Bank (1943-1978)	2.65	6.06
Float
Full period (1979-1998)	4.03	6.41
EMS (1979-1993)	2.40	7.85
Floating (1994-1998)	8.92	2.08
Euro era
Euro (1999-2016)	2.73	2.05

In the post-Maastricht period (1993-99), Ireland moved towards monetary integration with the euro area. This marked a de facto return to a currency union that mostly mirrored its pre-independence regime. Over the period between 1979 and 1999, Ireland’s economy had opened to the large EEC/EU market.

Throughout the years 1993-2007, the economy grew at almost 6% per annum and the debt ratio fell by 70 percentage points, with consistent fiscal surpluses. Ostensibly, Ireland’s position was favourable throughout the 1990s, as stronger growth and falling interest rates created a situation where the required primary balance to stabilise debt was negative (see Table 2). This implies that primary deficits could have transpired without causing an increase in the debt ratio. On the face of it, this looked like positive news.

Table 2: Fiscal sustainability data, Ireland 1992-2014

Source: Data from FitzGerald and Kenny, 2019

Note: b* is calculated as d(i-pi-g) where d = the debt ratio, b is the actual primary budget balance as it transpired, the nominal rate of interest is i and the deflator is pi. The debt stabilising primary balance, b*, is the primary deficit required to keep the current debt ratio at its current level, given the other determinants. Authors’ calculations.

But some analysts noted the increased openness of the Irish economy in a currency union and sought to explain what this would imply for the evaluation of fiscal policy under European economic and monetary union (Lane, 1998). Stressing the importance of the long-term perspective, it was argued that policy should be evaluated by the structural fiscal balance (medium term, excluding the effects of the economic cycle and one-off measures), despite associated measurement problems (Darvas, 2013).

The structural balance is concerned with revealing the medium term fiscal stance, offering policy-makers the ability to avoid the pitfalls of pro-cyclical fiscal policy – when governments increase government spending and reduce taxes during an economic expansion, but reduce spending and increase taxes during a recession (Lane, 1998). By relying on a longer-term measure such as a structural balance, authorities are comparatively sheltered from political pressures to expand during transitory booms. The capacity to enact counter-cyclical fiscal policy during a downturn is thereby strengthened.

Pro-cyclical fiscal policy was especially dangerous in Ireland’s case as a small open economy, due to its greater vulnerability to external shocks, the lack of synchronisation of its business cycle with European partners and the gradual reduction of EU funds (International Monetary Fund, IMF, 1998). A number of subsequent studies revealed that Ireland’s fiscal stance was persistently pro-cyclical (Bénétrix and Lane, 2012; FitzGerald, 2011; Kearney et al, 2000; Kearney, 2012).

If one had relied alone on the standard annual fiscal sustainability data presented in Table 2, it would have been difficult to claim that fiscal policy was pro-cyclical. As late as 2006, Ireland’s primary gap (the difference between the debt-stabilising and actual primary balances) was positive at 6% of GDP. These figures provided a false sense of security for policy-makers as they were evaluated on an annual rather than medium-term basis. Using a structural balance approach, which considers the medium term, the required fiscal surpluses should have been considerably higher, especially given the unprecedented growth rates that transpired during the boom (Bénétrix and Lane, 2012).

If such counter-cyclical policy had been pursued, some of the excesses of the boom may have been tamed and the fiscal capacity of the state to respond to the global financial crisis in 2007-09 may have been strengthened. The subsequent 2010 sovereign default arose both from the cost of supporting the Irish banking system and from the fact that the European Central Bank (ECB) was unwilling to purchase government bonds of member states (de Grauwe, 2013). The lack of an operational banking union meant that the cost of rescuing national banks remained national without federal level takeovers (Gros, 2012).

The absence of a fiscal union meant that automatic stabilisers were absent from the recovery of crisis countries, which were obliged to undertake painful internal devaluation via fiscal austerity (de Grauwe, 2018). As we have seen, the pro-cyclical fiscal policy that was pursued during the boom left the ability of the state to respond considerably weaker. The European (Irish) approach stands in contrast to the UK alternative, where, during the financial crisis of 2007-09, the Bank of England acted as lender of last resort to both the banks and the state, regional banks were reconstructed with central funds and fiscal transfers were forthcoming from the centre.

What lessons can be drawn from the Irish example?

The IFS approached monetary and fiscal policy with extreme caution after independence. Based on external recommendations, a currency board was established to maintain a peg to sterling, with the important option to review this when the size and variety of Ireland’s trade changed. This regime lasted for 57 years.

As a small country highly integrated with its nearest neighbour, Ireland could not have exerted monetary independence had the option been open if such policy did not mirror the UK’s, as evidenced by the 1955 crisis. After Ireland eventually exercised monetary independence for a short period, it again opted to join a hard currency regime with the ultimate step in 1999 of abandoning its currency and adopting the euro. The current regime mostly resembles the pre-independence pound, with monetary policy and the supply of currency in the hands of a larger trading partner.

Maintaining the sterling peg for so long after independence came with its own costs and benefits. The immediate post-independence period coincided with hyperinflation, depression and a global drive towards protectionism. In this light, sterling was a safe haven. Yet maintaining the sterling peg placed considerable constraints on fiscal policy and effectively kept the Irish economy tied to the fate of the neighbouring isle.

While an independent Scotland may wish to set up an independent central bank, the experience of Ireland suggests that adopting a de facto central bank with a flexible currency board style arrangement may be a suitable approach. The benefit of flexibility in a currency board arrangement is something that has been discussed in relation to the monetary arrangements in the aftermath of the dissolution of the Soviet Union (Ghosh et al, 2000).

Such an approach shields policy-makers from certain political pressures, while offering the credibility and policy space to alter the regime, when the composition and volume of trade warrants. While fiscal policy under such a regime is the only remaining economic policy tool available, it is limited to the extent that a fiscal union exists that is independent of regional conditions (de Grauwe, 2018).